BUSINESS  ADMINISTRATION 


"-[  SAMUEL  D.  HIRSCHL,  S.B.,  J.D. 

.  L         Member  of  the  Illinois  Bar 


The  texts  listed  on  this  page  form  the  basic  material  for  the 
LaSalle  Business  Administration  Course  and  Service.  They 
constitute  a  library  of  standard  practice  in  all  the  important 
divisions  of  business  management. 

Titles  Authors 

BUSINESS  PSYCHOLOGY  .    HUGO  MUNSTERBERG,  Ph.D.,  M.D.,  LL.D. 

Harvard   University 

PERSONAL  EFFICIENCY,  AP- 
PLIED SALESMANSHIP, 
AND  SALES  ADMINISTRA- 
TION   IRVTNC  R.  ALLEN 

Sales  Counselor 

BUSINESS  LAW  I  .  . 
BUSINESS  LAW  II  . 
BUSINESS  ENGLISH  EDWIN  HERBERT  LEWIS,  Ph.D.,  LL.D. 

Lewis  Institute,  Chicago 

BUSINESS  ECONOMICS      .     .     ERNEST  LUDLOW  BOGART,  Ph.D. 

University  of  Illinois 

INDUSTRIAL  ORGANIZA- 
TION AND  MANAGEMENT  .     HUGO  DIEMER,  M.E. 

Pennsylvania   State   College 

AMERICAN    BANKING     .     .     .    HENRY  PARKER  WILLIS,  Ph.D. 

Secretary,  Federal  Reserve  Board 

INVESTMENTS  AND  SPECU- 
LATION   LOUIS  GUENTHER 

Editor,   "Financial   World" 

ORGANIZING  A  BUSINESS     .     MAURICE  H.  ROBINSON,  Ph.D. 

University  of  Illinois 

FINANCING  A  BUSINESS  .     .     ELMER  H.  YOUNGMAN 

Editor,  "Bankers  Magazine" 

ADVERTISING E.  H.  KASTOR 

H.  W.  Kastor  &  Sons 

RETAIL  MERCHANDISING          PAUL  NEYSTROM,  Ph.D. 

Van   Cleve   Co.,   New   York 

EDWARD  M.  SKINNER 

CREDITS   AND   COLLEC-  ,    Manager,  Wilson  Bros. 

TIONS  1  R-  s-  WHITE 

American  Steel  &  Wire  Co. 

[  H.  E.  KRAMER 
RAILWAY  REGULATION     .    .     I.  L.  SHARFMAN,  A.B.,  LL.B. 

University  of  Michigan 

OCEAN  TRAFFIC  AND 
TRADE B.  OLNEY  HOUGH 

Editor,  "American  Exporter" 

PRINCIPLES  OF  ACCOUNT- 
ING   STEPHEN  GILMAN,  B.  S. 

OFFICE  ORGANIZATION  AND 
MANAGEMENT C  C.  PARSONS 

Manager,  Shaw-Walker  Co. 


LASALLE  EXTENSION  UNIVERSITY 


PRINCIPLES  OF  ACCOUNTING 


STEPHEN  OILMAN,  B.  S. 

Department  of  Higher  Accountancy,   LaSalle  Extension  University 

Former  Credit  Manager,  Tennessee  Coal, 

Iron  &  Railroad  Company 


Extension  University 

Chic  a  go 

1916 


Copyright,  1916 
LASALLE  EXTENSION  UNIVERSITY 


PREFACE 

Within  recent  years  there  has  been  a  noticeable  growth 
of  interest  in  scientific  accounting.  The  day  of  the  tradi- 
tional bookkeeper  whose  principal  interest  was  to  keep 
his  books  in  balance  is  rapidly  passing,  and  his  place  is 
being  taken  by  an  executive — the  scientific  staff  auditor, 
whose  field  is  as  wide  as  the  extent  of  the  business  itself. 
Many  have  been  attracted  by  the  exceptional  opportuni- 
ties afforded  by  accountancy  and  have  eagerly  perused 
such  texts  as  were  available.  During  the  past  decade,  a 
number  of  excellent  books  have  been  added  to  the  litera- 
ture of  the  accounting  profession,  but  most  of  such  works 
have  been  written  as  reference  books  for  the  professional 
public  accountant. 

Under  these  conditions,  one  who  has  been  denied  a  long 
training  in  the  school  of  experience,  upon  seeking  to 
acquire  a  comprehensive  grasp  of  accounting  science, 
finds  that  most  treatises  on  the  subject  are  better  suited 
for  reference  purposes  than  for  mastering  the  working 
principles  of  accounting  in  a  systematic  and  organized 
manner. 

In  the  following  pages  the  author  has  endeavored  to 
develop  the  fundamental  principles  of  accounting  science 
according  to  a  basic  plan.  A  number  of  illustrations  and 
problems  are  given  to  illuminate  the  textual  discussion. 
The  purpose  of  the  book  is  not  to  promulgate  the  special- 
ized treatment  of  any  particular  phase  of  the  subject,  but 
rather  to  present  the  basic  principles  of  the  science  of 
accounting  in  a  graphic  and  comprehendible  manner. 

iii 


iv  Preface 

While  it  is  not  believed  that  any  text  on  accounting 
principles  would  prove  inappropriate  for  the  layman,  the 
following  pages  have  been  written  primarily  for  those 
having  some  training  or  experience  in  the  art  of  book- 
keeping. 

The  author  believes  that  no  apology  is  necessary  for 
"personifying  the  business, "  since  experience  indicates 
the  desirability  of  this  approach  to  the  subject  of  account- 
ing theory.  It  is  nowhere  maintained  that  proprietorship 
accounts  reflect  a  legal  liability ;  rather  they  reflect  a  theo- 
retical one,  and  this,  after  all,  is  the  crux  of  the  argument. 

The  author  desires  to  express  his  appreciation  and  to 
give  due  credit  to  his  father,  Professor  Stephen  W. 
Oilman,  A.  B.,  LL.  B.,  C.  P.  A.,  of  the  University  of 
Wisconsin,  for  his  invaluable  assistance  in  reading  the 
manuscript,  and  to  his  colleague,  Mr.  John  B.  Tanner, 
C.  P.  A.,  for  his  many  helpful  suggestions. 


CONTENTS 

I.     PRELIMINARY  SURVEY 

Symbols   1 

Symbolizing  the  Account 2 

Disadvantages  of  Balance  Method 11 

The  Account 19 

II.     BASES  OF  ACCOUNTING 

The  Ledger 21 

Account  Relations 23 

The  Trial  Balance 24 

Analysis  of  Accounts 26 

Proprietor's  Account   29 

Subsidiary  Proprietor's  Account 30 

Nominal  and  Real  Accounts 33 

Development  of  the  Merchandise  Account. ...  33 

Inventories    34 

Mixed  Accounts 35 

The  Accounting  Period 36 

Balance  Sheet  and  Profit  and  Loss  Statements.  37 

The  Journal   39 

Posting 40 

The  Controlling  Account  and  Subsidiary  Ledger  42 

Control  Accounts  and  Double  Entry 43 

Other  Controlling  Accounts 43 

Incomplete  Double  Entry 44 

Positive  and  Negative  Inventories 46 

Liability  Inventories 49 

Conclusion   50 

III.     DEVELOPMENT  OF  THE  SPECIAL  JOURNALS 

Function  of  the  Journal 53 

Columnar  Journal 55 

V 


vi  Contents 

Specialized  Journals 60 

Cash  Discounts 71 

Notes  and  Bills  Journals 75 

Special  Journals  and  Control  Accounts 77 

The  Ledgers  78 

The  Private  Ledger 79 

Other  Uses  of  the  Private  Ledger 83 

The  Ledger  Account 84 

The  Columnar  Ledger 88 

The  Columnar  Purchase  Journal 89 

The  Voucher  Eegister 89 

The  Status  of  the  Journal 97 

Posting  Technique 101 

Conclusion   104 

IV.     THE  BALANCE  SHEET 

The   Trial  Balance 106 

Profit  and  Loss  Account. 110 

Form  of  Balance  Sheet 113 

Limitations  of  the  Balance  Sheet 115 

The  Working  Balance  Sheet 116 

Adjusting  Entries 118 

Explanation  of  Adjustments , 121 

Underlying  Principles    126 

Summary   134 

Form  of  the  Balance  Sheet 142 

Construction  of  the  Balance  Sheet 144 

The  Seven  Steps '145 

Nature  of  Depreciation 147 

Incomplete  Double  Entry 152 

Conclusion   153 

V,     ASSETS  AND  THEIR  VALUATION 

Primary  Classification  of  Assets 157 

Definitions 157 

The  Economic  Cycle 158 

Primary  Basis  of  Valuation 16U 


Contents  vii 

Valuation  of  Current  Assets 160 

Debts  Eeceivable  162 

Notes  Receivable 165 

Bills  Receivable  167 

Merchandise  or  Finished  Goods  Account 167 

Working  Assets  167 

Fluctuating  Values  168 

Elements  of  Book  Cost 169 

Materials  in  Process 170 

Material  and  Supply  Accounts 171 

Accounting  for  Materials 172 

Mixed  Assets 178 

Land 182 

Land  Purchased  with  Stocks  or  Bonds 184 

Buildings   184 

Leaseholds 186 

Machinery   187 

Investments  188 

Deferred  Assets 191 

Intangible  Fixed   Assets 191 

Goodwill 192 

Franchises  and  Patents 195 

Organization  Expense 196 

VI.    LIABILITIES 

Current  Liabilities 197 

Accrued  Liabilities 198 

Other  Current  Liabilities 199 

Deferred  Liabilities 199 

Contingent  Liabilities 200 

Bonded  Indebtedness   203 

VII.    PROPRIETORSHIP 

Mixed  Elements  of  Proprietorship 212 

Proprietorship  Entries  215 

Subsidiary  Accounts 216 

Three  Classes  of  Proprietorship 217 


viii  Contents 

Corporation  Proprietorship 220 

Classification  of  Nominal  Accounts 222 

Expense    Classification 224 

Profit  and  Loss  Statement .  228 

Manufacturing  Statement 233 

Balance  Sheet  and  Profit  and  Loss  Statement. .  237 

The  Functional  Idea 238 

Model  Form  of  Statement 239 

Trading  Account 240 

Treatment  of  Errors 242 

Materials  and  Supplies 243 

Prime  Cost  246 

Manufacturing  Expense 246 

Factory  Profits 246 

Depreciation    247  ' 

Purchase  and  Sales  Discounts 248 

Insurance  and  Taxes 251 

Bad  Debts 251 

Closing  the  Ledger 252 

Statement  of  Receipts  and  Disbursements 253 

Railroad  Income  Statements 253 

VIII.     PROPRIETORSHIP — Continued 

General  Ledger  Control 263 

Apportionment  Accounts 265 

Treatment  of  Supplies 266 

Summary   266 

Clearing  Accounts 267 

Bases  of  Distribution 269 

IX.     PARTNERSHIP 

Articles  of  Partnership 276 

Junior  Partners 277 

Formation  of  a  Partnership 278 

Interest  on  Capital 281 

Liquidation  of  Partnership 284 


Contents  ix 

X.  CORPORATIONS 

Capital  Stock  296 

Corporate  Books 297 

Corporation  Proprietorship  Accounts 300 

Reserves   301 

Premium  on  Stock 302 

Discount  on  Stock 303 

Unissued  and  Treasury  Stock 303 

Opening  Entries   305 

Donated  Stock   310 

Corporate  Profits  and  Dividends 321 

Mining   Companies    323 

Realized  Profits  324 

Scrip  and  Stock  Dividends 325 

XI.  RESERVE  AND  RESERVE  FUNDS 

Valuation  Accounts 329 

True  Reserves  . . .. 330 

Effect  on  Balance  Sheet  Interpretation 332 

Reserve  Funds 335 

Sinking  Funds 337 

Sinking  Fund  Installments 339 

Secret  Reserves 342 

Summary 343 

XII.     DEPRECIATION 

Depreciation  a  Cost 347 

Fluctuation  and  Depreciation 348 

Appreciation   349 

Causes  of  Depreciation 349 

Contingent  Depreciation    352 

Replacements    353 

Plant  Ledger 353 

The  Rate  of  Depreciation 356 

Depreciation  Methods 358 

Reducing  Balance  Method 360 

Revaluation   .                                                         .  362 


x  Contents 

Working  Hours  362 

Annuity  Method    364 

Sinking  Fund  Method 365 

Comparison  of  Methods 367 

''Dollar  Years"  Method 367 

Other  Methods   368 

Repairs  and  Maintenance 369 

Renewals    369 

Conclusion   370 

XIII.  SPECIAL  FORMS  OF  STATEMENTS 

The  Statement  of  Affairs 372 

Proprietorship  Items 376 

Reserves  377 

The  Deficiency  Account 378 

Statement  of  Realization  and  Liquidation 383 

Method  of  Construction 384 

Receiver's  Operations 386 

Treatment  of  Cash 387 

XIV.  THE  HOLDING  COMPANY  AND  THE  CONSOLIDATED  BALANCE 

SHEET 

The  Accounting  Problems 397 

True  Balance  Sheet 399 

Consolidated  Balance  Sheet 399 

Elimination  of  Interrelations 400 

Working  Form    401 

Goodwill 401 

Minority  Interests 406 

Intercompany  Sales 407 


LIST  OF  FORMS  AND  ILLUSTRATIONS 

Pigs.  1-11   (incl.).     Graphical  Illustrations  of  the  Funda- 
mental Accounting  Equation 3-18 

Pig.  12.     Traditional  Journal  Form 39 

Fig.  13.     Illustration  of  Transactions  Using  Regular  Jour- 
nal Form 57 

Pig.  14.     Illustration  of  Transactions  Using  Columnar  Jour- 
nal      59 

Fig.  15.     Columnar  Journal 61 

Fig.  16.     Sales  Journal   63 

Fig.  17.     Purchase  Journal    64 

Fig.  18.     Cash  Receipts  Journal 65 

Fig.  19.     Columnar  Cash  Receipts  Journal 66 

Fig.  20.     Cash  Disbursements  Journal 67 

Fig.  21.     Cash  Journal  Which  Is  Used  Purely  as  a  Posting 

Medium    69 

Fig.  22.     Cash  Journal  Which  Is  Used  as  a  Posting  Medium 

and  Which  Also  Serves  as  a  Cash  Account ...  69 
Fig.  23.     Columnar  Journal  When  Used  as  a  Posting  Me- 
dium for  Notes  Received  and  Given 71 

Fig.  24.     Cash  Receipts  Journal,  Showing  Method  of  Hand- 
ling Sales  Discounts 73 

Fig.  25.     Cash  Disbursements  Journal,  Showing  Method  of 

Handling  Purchase  Discounts 74 

Fig.  26.     Posting  Medium  for  Notes  and  Bills  Receivable . .  76 

Fig.  27.     Accounts  Receivable  Ledger  Page 85 

Fig.  28.     Accounts  Receivable  Ledger  Page 86 

Fig.  29.     Accounts  Receivable  Ledger  Page 87 

Fig.  30.     Columnarized  Purchase  Journal 88 

Fig.  31.     Front  of  Voucher  Jacket 92 

Fig.  32.     Reverse  of  Voucher  Jacket  Shown  in  Fig.  31 92 

Fig.  33.     Cash  Disbursements   94 

Pig.  34.     Voucher  Register 95 

Fig.  35.     Front  of  Journal  Voucher 98 

Fig.  36.     Reverse  of  Journal  Voucher  Shown  in  Fig.  35 ....  99 
Fig.  37.     Journal  Voucher  Which  Is  to  Be  Bound  and  Used 

as  a  Posting  Medium 100 

Fig.  38.     Journal  Page   102 

Fig.  39.     Voucher  Register  and  Journal  Combined 103 

xi 


xii  List  of  Forms  and  Illustrations 

Fig.  40.     Six-Column  Statement 117 

Fig.  41.     Working  Balance   Sheet 119 

Fig.  42.     Working  Balance   Sheet 122 

Fig.  43.     Balance  Sheet  of  J.  J.  Williams 126 

Fig.  44.     Working   Balance   Sheet 136 

Fig.  45.     Balance  Sheet  in  Account  Form 142 

Fig.  46.     Balance  Sheet  in  Account  Form  144 

Fig.  47.     Balance  Sheet  in  Report  Form 146 

Fig.  48.     Machinery  Account 150 

Fig.  49.     Common  Forms  of  Stock  Ledger  Accounts 173 

Fig.  50.     Recapitulation  of  Requisitions 174 

Fig.  51.     Chart  Showing  Primary  Subdivision  of  Proprie- 
torship     214 

Fig.  52.     Chart  Showing  Classification  of  Expense  Accounts 

According  to  Objects  of  Expenditure 225 

Fig.  53.     Chart  Showing  Common  Classification  of  Expense 

Accounts    227 

Fig.  54.     Model  Statement  Form 228 

Fig.  55.     Statement  for  a  Merchandising  Organization ....   231 
Fig.  56.     Statement  for  a  Manufacturing  Organization ....   232 

Fig.  57.     Manufacturing  Statement  233 

Fig.  58.     Complete  Statement  for  Manufacturing  Organiza- 
tion     234 

Fig.  59.     Statement  for  Manufacturing  Organization  in  Ac- 
count Form 235 

Fig.  60.     Statement    for    Manufacturing    Organization    in 

Somewhat  Different  Form 236 

Fig.  61.     Illustration  of  the  Profit  and  Loss  Statement  for 
the  Problem  Discussed  in  Chapter  IV,  pages 

134  to  141 241 

Fig.  62.     Raw  Materials  Control  Account 244 

Fig.  63.     Supplies  Control  Account 245 

Fig.  64.     Closing  Journal  Entries 254 

Fig.  65.     Ledger  Accounts  after  Closing 255 

Fig.  66.     Railroad  Income  Statement 256 

Fig.  67.     Organization  Chart 260 

Fig.  68.     Chart  Illustrating  Functional  Classification  of  Ac- 
counts    264 

Fig.  69.     General  Ledger  Clearing  Accounts 273 

Fig.  70.     Stock  Ledger  Page  Ruling 299 

Fig.  71.     Plant  Ledger  Page' 355 

Fig.  72.     Chart  Illustrating  Depreciation  Methods 359 

Fig.  73.     Suggested  Form  for  Statement  of  Affairs 374 

Fig.  74.     Charts  Illustrating  Lines  of  Stock  Control  of  a 

Holding  Company 404 


PRINCIPLES  OF  ACCOUNTING 

CHAPTER  I 

PRELIMINARY  SURVEY 

An  individual  engaged  in  business  might  conduct  that 
business  successfully  without  keeping  records.  He  could 
do  so  only  if  the  business  was  small  and  the  transactions 
such  as  to  be  remembered  easily.  As  a  matter  of  fact, 
no  business,  however  simple  in  its  nature,  does  entirely 
without  records  of  some  sort,  primitive  though  they  may 
be.  As  business  becomes  complex,  adequate  records  are 
essential.  The  reason  for  this  is  the  inability  of  any 
human  being  to  remember  complicated  transactions 
accurately.  Man,  therefore,  symbolizes. 

SYMBOLS 

Symbols  of  one  sort  or  another  have  been  in  use  by  the 
human  race  since  the  beginning  of  recorded  time.  A 
"symbol"  is  that  which  stands  for  or  represents  some- 
thing «lse ;  a  visible  sign  or  representation  of  an  idea  or 
quality  or  of  another  object.1  Thus  the  heathen 's  idol 
is  a  symbol.  Maps,  drawings,  and  paintings  are  symbols. 
A  baseball  Scoreboard  is  a  symbol.  Models  of  all  sorts 
are  symbols.  The  printed  or  written  word  is  a  symbol. 

In  the  chief  engineer's  office  in  Panama  there  is  a 
small-scale  working  model  of  the  canal.  Every  detail 
is  complete.  By  means  of  electrical  control  every  opera- 

i  Webster's  New  International  Dictionary, 

1 


2  Principles  of  Accounting 

tion  taking  place  anywhere  on  the  canal  is  reproduced 
in  miniature.  Ships  move  from  one  ocean  to  another; 
locks  open  and  close.  All  normal  functions  are  symbol- 
ized. The  chief  executive  may  watch  this  working  model 
and  exercise  adequate  control  over  the  activities  of  his 
entire  organization.  He  has  the  same  comprehensive 
viewpoint  as  that  which  an  aviator  would  have  when 
flying  over  the  canal  zone.  The  importance  of  the  word 
" comprehensive"  is  very  great  because  it  illustrates  the 
chief  function  of  a  symbol. 

The  highly  complex  business  must  utilize  this  principle 
if  it  is  to  be  managed  adequately.  Managers  work  with 
the  aid  of  symbols  almost  entirely  in  order  that  they  may 
obtain  a  comprehensive  view  of  their  business,  which  is 
possible  in  no  other  way. 

SYMBOLIZING  THE  ACCOUNT 

Every  reader  is  familiar  with  the  usual  bookkeeping 
symbol — the  account.  For  the  sake  of  bringing  out  cer- 
tain important  principles,  another  symbol  may  be  tem- 
porarily adopted.  This  symbol  is  the  ordinary  pair  of 
scales  or  balances.  For  illustration  let  us  assume  a 
very  simple  case  and  then  apply  this  symbol  to  it.  An 
individual  named  Brown  is  employed  as  business  manager 
by  Ames.  Ames  is  entitled  to  all  profits  and  is  respon- 
sible for  all  losses,  Brown  being  paid  a  salary. 

Inasmuch  as  Brown  is  responsible  for  results  to  Ames, 
he  must  keep  a  record  of  all  business  transactions  as  an 
aid  to  administrative  data.  He  may  do  so  by  visualizing 
or  symbolizing  the  different  business  transactions  which 
take  place,  with  the  aid  of  balances  or  scales  and  some 
small  metal  cubes,  each  representing  one  dollar.2 

2  This  and  following  illustrations  are  for  the  purpose  of  developing  the 
fundamental  theory  of  double  entry  accounts  and  should  not  be  taken  seri- 


Preliminary  Survey  3 

At  the  beginning  of  business  Ames  may,  for  the 
purpose  of  this  illustration  of  primitive  transactions, 
be  considered  to  have  invested  $15.00  in  cash.  This  is 
recorded  (Figure  1)  and  may  be  illustrated  by  depositing 
fifteen  metal  cubes  in  the  scalepan  marked  and  assumed 
to  represent  "assets"  and  another  fifteen  in  the  one 
marked  "liabilities."  By  this  means  is  recorded  the 
fact  that  the  business  has  come  into  the  possession  of 
certain  assets  ($15.00  in  cash)  and  owes,  or  must  account 
for,  an  equivalent  amount  ($15.00  to  Ames). 

ASSETS  LIABILITIES 


$15.00 
TilbOTotd  Totolfl5.00 

FIG.  1. — Registering  the  Investment 

Suppose  Brown  took  $10.00  and  bought  10  bushels  of 
grain.  How  would  he  record  this  by  the  symbols  1  The 
difficulty  is  obvious,  since  he  has  simply  exchanged  one 
asset  for  another.  If,  however,  we  replace  the  scalepan 
on  the  left  side,  previously  described,  with  two  scalepans 
and  label  one  "cash"  and  the  other  "merchandise"  this 
transaction  can  be  illustrated.  (See  Figure  2.) 

Suppose  Brown  sells  5  bushels  of  the  grain  for  $6.00. 
What  adjustment  of  the  balance  must  he  make?  Since 
one-half  of  the  grain  ($5.00  worth)  has  been  dispensed, 
he  must  take  five  of  the  weights  out  of  the  "merchandise" 
scalepan,  and  since  the  business  received  $6.00,  he  must 

ously  with  regard  to  the  transactions  themselves,  the  amounts  involved,  or 
other  matters  not  pertinent  to  the  development  of  principles. 


Principles  of  Accounting 


put  six  weights  in  the  "cash"  scalepan.  When  he  does 
this,  the  several  scales  no  longer  balance  in  the  aggregate, 
since  there  are  sixteen  weights  in  the  pans  on  one  side 


ASSETS 


LIABILITIES 


$15.00 


fclS.OO 


$15.00  Total  Total* 1 5.00 

FIG.  2  (a). — Condition  before  Buying  the  Grain 


ASSETS 


LIABILITIES 


sio.oo 

$15.00  Total 


I  5.00       /          I  I  I  I  I  | 


$15.00 


Total  115.00 


FIG.  2  (b). — Condition  after  Buying  the  Grain 


and  only  fifteen  on  the  other.  This  discrepancy  is  caused 
by  the  fact  that  $5.00  worth  of  grain  was  sold  for  $6.00, 
resulting  in  a  one-dollar  profit.  To  whom  does  this  profit 
belong?  To  the  proprietor,  Ames.  It  is  to  be  accounted 


Preliminary  Survey  5 

for  by  the  business  to  the  proprietor.  Being  in  the  nature 
of  a  liability  it  must  be  recorded,  and  this  is  done  by 
putting  one  weight  in  the  liability  scalepan.  (See 
Figure  3.) 

Brown  buys  10  more  bushels  of  grain  at  $1.00  per 
bushel,  but  instead  of  paying  for  it  he  buys  on  account. 
He,  therefore,  must  register  an  asset  and  a  liability  of 
the  same  amount,  viz.,  $10.00.  He  can  put  ten  weights 
in  ' '  merchandise ' '  and  ten  weights  in  ' '  liabilities. ' r  One 


ASSETS  LIABILITIES 


$11.00 


SI  6.00 


FIG.  3. — Condition  after  Selling  Five  Bushels  of  Grain  (Cost  $5.00)  for  $6.00 

objection  to  this  is  that  he  is  not  properly  distinguishing 
between  liabilities  to  an  outsider  (for  $10.00)  and  to  the 
proprietor,  Ames  (for  $16.00).  Brown  will  want  to  keep 
them  separate  because  Ames  is  entitled  to  all  profits  and 
is  responsible  for  all  losses,  while  the  outsider  is  entitled 
to  only  $10.00  in  any  event.  This  distinction  can  be 
easily  made  by  hanging  two  scalepans  instead  of  one  on 
the  liability  side.  (See  Figure  4.) 

The  business,  let  us  assume,  does  not  have  to  pay  for 
the  grain  for  thirty  days,  but  Brown  offers  to  pay  $9.00 
immediately  in  settlement  of  the  entire  account.  This  is 


6 


Principles  of  Accounting 


accepted.  An  analysis  of  the  transaction  shows  that 
$9.00  in  cash  is  parted  with  by  the  business;  therefore 
nine  of  the  weights  come  out  of  "cash."  The  entire 
liability  of  $10.00  has  been  wiped  out,  which  means  that 
ten  weights  must  be  taken  from  the  scalepan,  "liabilities 
to  others."  When  this  has  been  done,  the  scales  are 
again  out  of  balance,  there  being  one  more  weight  in 
the  pans  on  the  left-hand  or  asset  side  than  on  the  right- 


ASSETS 


LIABILITIES 


$15.00 
$26.00  Total 


$10.00 


$16.00 
Total  $26.00 


FiG.  4. — Condition  after  Buying  Ten  Bushels  of  Grain  on  Account 

(Cost  $10.00) 

hand  or  liability  side.  This  is  because  a  profit  amounting 
to  $1.00  has  been  made,  which  must  be  accounted  for  to 
Ames,  the  proprietor.  When  one  weight  is  put  in  his 
scalepan  representing  this  obligation,  a  balance  is  struck, 
showing  that  equilibrium  has  been  re-established.  (See 
Figure  5.) 

Ten  bushels  of  grain  are  now  sold  for  $12.00,  but 
instead  of  giving  cash  the  purchaser  gives  his  verbal 
promise  to  pay  $12.00  in  thirty  days.  Another  scalepan 
(which  may  be  labeled  "accounts  receivable")  must  be 
hung  on  the  left-hand  or  asset  side  to  register  this  class 


Preliminary  Survey 


7 


ASSETS 


LIABILITIES 


$2.00 


R 


$15.00 


$17.00  Total 


_      $17.00 
Total  $17.00 


FIG.  5. — Condition  after  Discounting  Bill  of  $10.00  for  $9.00  and 
thus  Gaining  $1.00 


$  100* 


$  5.00 


ASSETS 


1 


$12.00 
$19.00  Total 


LIABILITIES 


,$19.00 


Total  $19.00 


FIG.  6.— Condition  after  SeUing  Ten  Bushels  of  Grain  for  $12.00  on  Account 
and  thus  Making  a  Profit  of  $2.00 


8 


Principles  of  Accounting 


of  asset  ("promise  to  pay").  Twelve  weights  are  put 
in  "accounts  receivable, "  and  ten  are  taken  out  of 
"  merchandise "  as  the  grain  is  dispensed.  To  obtain 
the  balance  and  to  register  properly  the  obligation  of  the 
business  to  account  to  Ames  for  the  $2.00  profit  on  the 
sale,  two  weights  are  put  in  the  appropriate  scalepan. 
(See  Figure  6.) 


ASSETS 


LIABILITIES 


$13.00 


$  5.00 


$18.00 


$18.00  Total 

FIG.  7. — Condition  after  Allowing  Discount  of 
Eeceivable 


Total  $18.00 

L.OO  on  Accounts 


Brown  gives  permission  to  discount  the  bill  of  $12.00 
for  $11.00  in  cash.  This  will  be  registered  by  deducting 
twelve  weights  from  "accounts  receivable"  (because  that 
account  is  settled  in  full)  and  adding  eleven  weights  to 
"cash"  (because  that  is  the  exact  amount  received). 
The  difference  is  due  to  the  loss  of  $1.00  suffered  in  the 
transaction  and  is  registered  by  deducting  one  weight 
from  "Ames."  (See  Figure  7.) 


Preliminary  Survey 


Kent  of  $1.00  is  now  due  and  payable,  and  Brown 
therefore  pays  it  in  cash.  This  is  handled  by  deducting 
one  weight  from  "cash"  and  also  one  from  "Ames," 
since  he  is  responsible  for  all  expenditures.  (See 
Figure  8.) 


ASSETS 


LIABILITIES 


$12.00 


MERCHAND1SE> 
f  5.00  /  I  I  •'!  I  ' 


$17.00 


117.00  Total 


Total  $17.00 


FIG.  8. — Condition  after  Paying  Bent  of  $1.00 


Certain  fixtures  amounting  to  $8.00  are  needed  and  are 
bought  on  account.  (See  Figure  9.) 

The  transactions  pictured  in  Figures  1  to  9  having  been 
followed  through,  it  becomes  apparent  that  this  method  of 
"symbolizing"  the  business  is  satisfactory  in  a  primitive 
way,  but  that  it  has  certain  grave  defects.  It  shows,  at 
all  times,  the  current  state  of  affairs  as  to  property  and 
debts,  but  it  tells  no  history.  It  is  an  indicator  of  present 
conditions  and  not  a  recorder.  This  is  because  both 
additions  and  deductions  of  weights  are  made  in  each 


10 


Principles  of  Accounting 


of  the  various  scalepans.  This  could  be  remedied  by 
having  two  scalepans  for  each  class  of  item  whether  it 
is  an  asset  or  a  liability.  Such  an  arrangement  is  shown 
in  Figure  10.  With  this  arrangement  no  subtractions 


ASSETS 


LIABILITIES 


$12.00 


$  6.00 


$  5.00 


SI  7.00 


18.00 

$25.00  Total   '  Tool  $25.00 

PiG.  9. — Condition  after  Buying  Fixtures  on  Account  for  $8.00 

are  ever  made,  but  the  same  result  is  obtained  by  making 
additions  on  the  other  side.  This  is  a  considerable  im- 
provement, since  by  labeling  the  weights  with  the  date 
they  were  put  on  the  balance,  an  examination  would  give 
a  graphic  picture  of  the  history  of  the  various  trans- 
actions on  any  given  date;  of  property  on  hand  at  any 


Preliminary  Survey  11 

given  date;  of  the  condition  of  Ames'  (the  proprietor's) 
account  on  any  given  date. 

Having  only  one  place  to  register  all  gains  (items  due 
to  Ames)  and  all  losses  (items  due  from  Ames)  makes 
it  difficult  to  analyze  the  sources  and  character  of  these 
various  typified  transactions  of  losses  and  gains,  and  it 
can  readily  be  seen  that  if  any  considerable  volume  of 
business  were  done,  it  would  be  important  to  know  and 
to  analyze,  in  detail,  the  various  loss  and  gain  facts. 

DISADVANTAGES  OF  BALANCE  METHOD 

This  system  of  illustration  by  using  a  pair  of  scales 
is  very  good  in  one  way;  i.  e.,  when  an  incomplete  record 
is  made — when  all  facts  are  not  recorded — the  scales  get 
out  of  balance  and  thus  automatically  indicate  an  error; 
but  there  are  certain  obvious  disadvantages  about  such 
a  primitive  arrangement  which  will  be  apparent.  These 
may  be  remedied  by  doing  away  with  the  actual  physical 
machinery  and  substituting  therefor  the  picture  or  rep- 
resentation of  such  a  pair  of  scales.  We  thus  forego  the 
advantage  of  an  automatic  loss  of  balance  whenever  an 
incomplete  record  is  made  but  make  up  for  it  many  times 
over  by  increased  convenience  and  effectiveness,  and  if 
figures  are  substituted  for  the  weights,  we  can  check  the 
correctness  of  our  balance  by  footing  the  sides  and  noting 
whether  or  not  they  are  equal.  The  date  of  the  trans- 
actions can  also  be  more  conveniently  recorded.  Figure 
11  shows  such  an  arrangement  using  figures  which  rep- 
resent the  same  results  attained  in  Figure  10. 

By  using  the  pair  of  scales  originally  suggested,  it  is 
clear  that  various  sets  or  pairs  of  scalepans  with  the 
numerous  weights  on  them  need  not  be  kept  hanging  on 
the  scale  beam  all  the  time.  They  might  be  kept  in 
separate  places  and  all  brought  together  at  periodic 


12 


Principles  of  Accounting 


1 1 3.00 


I  5.00 


ACCOUNTS  RECEIVABLE 


AMES 


IISiOOTotal 


$18.00 

Total  jmoo 


FIG.  10  (a). — Same  Condition  as  Shown  in  Fig.  7,  but  with  Different 
Arrangement  of  Scalepans 


Preliminary  Survey 


13 


$13.00 


$  5.00 


1.00 


ACCOUNTS  RECEIVABLE 


n \~$  1.00 


$19.00  Total 


$18.00 
Totil  $19.00 


FIG.  10   (b). — Condition  after  Paying  Kent  of  $1.00 


Principles  of  Accounting 


&I3.00 


ASSETS 
CASH 


$  1.00 


15.00 


MERCHANDISE 


$2.00 


ACCOUNTS  RECEIVABLE 


LIABILITIES 
TO  OTHERS 


TIG.  10  (c). — Condition  after  Losing  Two  Bushels  of  Grain  by  Fire 

This  loss  reduces  Ames'  credit  balance  by  $2.00,  bis  net  worth  now  being 
$15.00    ($18.00  —  $3.00)    offset  by  assets  as  follows: 

Cash    ($13.00  —  SI. 00)  =$12.00 

Merchandise  ($5.00  — -  $2.00)  =      3.00 


Total $15.00 


Preliminary  Survey 


15 


•13.00 


ASSETS 
CASH 


$15.00 


$4.00 


I  I  I  I  I  I         \     j 


MERCHANDISE 


ACCOUNTS  RECEIVABLE 


8.00 


Fiiiii         \     $  5  00 


UABIL1TIES 

TO  OTHERS 


AMES 


$  5.00 


$19.00 
$37.00  Total  Toul  $37.00 

Fig.  10  (d). — Condition  after  Buying  Five  Bushels  of  Grain  for  Cash  and 

Five  Bushels  on  Account,  Selling  Three  Bushels  on  Account  for 

$4.00,  and  Paying  $2.00  License  Fee  in  Cash 


16 


Principles  of  Accounting 


FIG.  11  (a). — Same  Condition  as  Shown  in  Fig.  10   (d)    (assumed 
date,  June  1,  1916) 


Preliminary  Survey 


17 


ACCOUNTS  RECDVABLE 


AMES 


Fig.  11    (b), — Condition  of  June  2,  1916,  after   (1)    Paying  the  Amount 

Owing  to  Others,  (2)  Collecting  One-Half  of  the  Accounts  Keceivable, 

(3)    Selling  $10.00  Worth  of  Grain  for  $12.00  in  Cash,  and 

(4)  Buying  $5.00  Worth  of  Merchandise  on  Account 


18 


Principles  of  Accounting 


ASSETSI 


\ 


ZLJS2 


12. 


c 


\ 


Qun 


rs. 


7"V 


z^ 


A 


A 


JTIES 


/    V 


f 


Fig.  11  (c). — By  the  Addition  of  Certain  Kulings  We  Convert  the  Balancing 

Arrangement  into  a  Practical  Working  Form  without  at  All 

Losing  Sight  of  the  Fundamental  Balancing  Principle 


Preliminary  Survey  19 

intervals  to  be  balanced  in  the  aggregate.  It  would  be 
necessary  to  have  them  all  brought  together  at  one  time, 
since  it  would  be  seldom  that  the  individual  pairs  would 
balance  alone.  The  combination  balance,  representing 
all  recorded  facts,  is  the  test  that  is  needed.  In  a  similar 
way  this  pictorial  balance  (Figure  11)  need  not  be  all 
on  one  sheet  of  paper.  A  separate  sheet  may  be  headed 
' '  Cash, ' '  another  one  ' l  Merchandise, ' '  another  '  '  Accounts 
Keceivable,"  a  fourth  "Liabilities  to  Others/'  and  a  fifth 
"Liabilities  to  Ames,"  and  so  on.  Totals  of  each  side  of 
each  sheet  may  be  taken,  and  these  total  figures  for  all  the 
sheets  may  be  incorporated  in  the  balance  even  though 
the  sheet  headed  "Cash"  might  be  separately  located 
from  the  one  headed  "Merchandise."  This  is  a  very 
important  point  since  it  allows  for  the  greatest  possible 
elasticity,  convenience,  and  efficiency  in  the  keeping  of 
records.  By  bringing  the  figures  together  in  one  place 
at  a  moment  of  time  at  the  end  of  regular  periods  for 
balancing,  the  test  for  completeness  of  record  may  be 
applied. 

THE  ACCOUNT 

Each  one  of  these  information  units  may  be  called  an 
"account"  Thus  we  speak  of  the  "Cash  Account,"  the 
"Merchandise  Account,"  etc.  The  word  "account"  is 
for  convenience  frequently  omitted  in  written  work,  in 
which  case  it  is  usual  to  indicate  the  meaning  as  follows : 
cash  referring  to  money  but  Cash  (capitalized)  referring 
to  "Cash  Account." 


20 


Principles  of  Accounting 
TEST  QUESTIONS 


1.  What  functions  are  served  by  symbols? 

2.  What   is   the   fundamental   characteristic   of   the   symbol 
employed  in  this  chapter? 

3.  How  would  Figure  10  (a)  appear  after  buying  10 
of  grain  on  account  for  $1.00  per  bushel  and  selling  13  ^" 
account  for  $2.00  per  bushel  and  paying  $5.00  f' 

4.  What  is  an  account? 


CHAPTER  II 

BASES  OF  ACCOUNTING 

The  left-hand  side  of  an  account  is  for  convenience 
called  the  "  debit "  side,  and  the  right  is  known  as  the 
"credit"  side.  The  law  of  balances  is  that  the  total 
figures  on  the  left  or  debit  side  representing  the  aggregate 
of  all  the  accounts  must  be  exactly  equal  to  the  total 
figures  representing  the  aggregate  of  all  the  accounts 
with  amounts  on  the  right  or  credit  side.  The  working- 
out  of  this  law  has  been  illustrated  in  the  preceding 
elementary  examples.  This  fundamental  conception  is 
called  the  "Law  of  Double  Entry,"  since  the  introduction 
of  the  several  figures  on  the  debit  or  credit  side  of  an 
account  is  called  "making  entries."  The  book  which 
contains  the  various  accounts  is  known  as  the  "Ledger." 

THE  LEDGER 

In  this  Ledger  we  have  a  device  or  mechanism  by  the 
aid  of  which  the  manager  of  a  business  may  obtain  a 
comprehensive  view  of  the  situation  of  business  as  a 
whole,  in  which  the  activities  of  the  business  are  reflected, 
and  by  which  the  history  of  the  business  is  recorded.  It 
is  a  "symbol"— a  representation — a  graphic  picture  of 
the  business.  The  mechanics  of  operating  this  device  is 
known  as  the  "art  of  bookkeeping";  the  act  of  adapting 
and  regulating  it  and  of  interpreting  its  results  is  called 
the  "science  of  accountancy."  Upon  the  ledger  page  is 
the  "account";  the  collection  of  ledger  pages  is  the 

21 


22  Principles  of  Accounting 

Ledger.  In  this  Ledger  is  an  account  for  every  class  of 
item  owned  by  the  business  (assets),  such  as: 

Cash  Account. 

Accounts  Eeceivable  Account. 
Notes  Eeceivable  Account. 
Merchandise  Account. 
Eeal  Estate  Account. 
Buildings  Account. 
Machinery  Account. 
Etc. 

These  accounts  may  themselves  be,  and  often  are,  sub- 
divided or  carved  up  into  smaller  units.  Thus  Machinery 
Account  might  be  eliminated  under  this  general  designa- 
tion, and  in  its  place  we  might  have 

Lathes. 

Milling  Machines. 

Planers. 

Etc. 

Or,  if  that  classification  were  not  desirable,  the  division 
might  be  made  departmentally  into 

Machinery,  Department  A. 
"  "  B. 

"  "  C. 

Etc. 

Thus  we  see  that  the  assets  may  be  recorded  either  in 
large  classes  or  in  smaller  ones,  but  the  finer  the  sub- 
division, the  greater  the  number  of  accounts  in  the 
Ledger,  since  each  classification  of  assets  will  have  an 
account  in  the  Ledger  to  represent  it. 

In  the  Ledger  we  also  have  an  account  for  every  class 
of  item  owed  by  the  business  (liabilities),  such  as: 


Bases  of  Accounting  23 

Accounts  Payable  Account. 

Notes  Payable  Account. 

Mortgages  Payable  Account. 

The  obligation  of  the  business  represented 

by  the  Proprietor's  Account. 
Etc. 

These,  like  the  assets,  may  be  analyzed  into  their  constit- 
uents. We  have  stated  that  this  Ledger,  this  collection 
of  accounts,  has  for  its  object  the  representation  of  the 
present  state  of  the  business  assets  ancHi abilities ;  hence 
it  follows  that  when  the  status  of  any  of  these  assets  or 
liabilities  changes,  a  corresponding  change  must  be  made 
in  the  proper  ledger  accounts.  If  this  is  not  done,  the 
accounts  will  no  longer  represent  or  reflect  the  truth  as 
to  the  business  and  will,  therefore,  not  be  performing 
their  proper  functions. 

When  the  business  parts  with  $10.00  in  money  for 
$10.00  worth  of  merchandise,  we  must  record  this  in  our 
ledger  account  by  entering  $10.00  to  the  credit  of  Cash 
and  $10.00  to  the  debit  of  Merchandise.  When  the  busi- 
ness sells  $10.00  worth  of  merchandise  for  $12.00  worth 
of  verbal  promises  to  pay,  we  must  debit  Accounts 
Receivable  $12.00,  credit  Merchandise  $10.00,  and  directly 
or  indirectly  credit  the  Proprietor  $2.00,  since  the  busi- 
ness owes  him  the  profit.  When  a  fire  burns  up  the 
store,  we  will  credit  Buildings  and  debit  directly  or 
indirectly  the  Proprietor's  Account,  since  the  Proprie- 
tor's Account  is  chargeable  with  all  losses. 

ACCOUNT  RELATIONS 

The  following  changes  are  the  only  ones  that  can  take 
place  in  a  business  and,  therefore,  the  only  ones  that  can 
be  reflected  by  the  ledger  accounts. 

1.  An   increase   in   an   asset,  which   will   always   be 


24  Principles  of  Accounting 

balanced  by  a  decrease  in  another  asset  or  an  increase 
in  some  liability  or  both. 

2.  A    decrease   in    an    asset,   which   will    always    be 
balanced  by  an  increase  in  another  asset  or  a  decrease 
in  some  liability  or  both. 

3.  An  increase  in  a  liability,  which  will  always  be 
balanced  by  a  decrease  in  another  liability  or  an  increase 
in  an  asset  or  both. 

4.  A   decrease  in   a  liability,  which  will   always   be 
balanced  by  an  increase  in  another  liability  or  a  decrease 
in  an  asset  or  both. 

The  reader,  by  referring  to  the  graphic  charts  on  pre- 
ceding pages  and  making  various  practical  experiments, 
may  test  the  accuracy  of  this  statement. 

THE  TRIAL  BALANCE 

The  periodic  testing  of  the  accounts  to  see  if  they  are 
in  balance  is  called  ' '  taking  a  trial  balance. ' ' 

A  trial  balance  may  be  in  two  forms :  a  balance  of  totals 
or  a  balance  of  balances.  For  the  ledger  accounts  shown 
on  the  next  page  the  trial  balance  of  totals  would  be  as 
follows : 

Debits  Credits 

Cash    $14,700.00  $12,350.00 

Merchandise    19,850.00  12,200.00 

Proprietor    2,500.00  12,500.00 


Totals    $37,050.00     $37,050.00 


A  trial  balance  of  balances  for  the  same  accounts  would 
appear  thus : 

Debits  Credits 

Cash    $  2,350.00 

Merchandise    7,650.00 

Proprietor $10,000.00 


Totals    $10,000.00     $10,000.00 


Bases  of  Accounting 


25 


CASH 


Jan.    1  

.  .(a) 

$1,000.00 
3,000.00 
4,300.00 
3,500.00 
2,900.00 

MERCH 

Jan.    2  

..(g) 

$  850.00 
2,000.00 
3,800.00 
3,200.00 
2,500.00 

5 

(b) 

6 

(h) 

15  

..(c) 

16  

..(i) 

20   ... 

.  .(d) 

21   .      .. 

.  .(k) 

30 

Ce) 

31 

(T\ 

ANDISE 

Jan.    1  

•  .  (f  ) 

$10,000.00 
850.00 
2,000.00 
3,800.00 
3.200.00 

Jan.    5  

..(b) 

$2,500.00 
4,000.00 
3,000.00 
2,700.00 

2 

.    (g) 

15   ... 

.  .(c) 

6 

(h} 

20 

(d} 

16  

.  .  (i) 

30     ... 

.  .(e) 

21.. 

..m 

PROPRIETOR 


Jan.  31 (1)  $2,500.00 


Jan.  1 (a)  $  1,000.00 

1 (f)   10,000.00 

5 (b) 

15 (c) 

20.. 


30. 


(d) 

(e) 


500.00 
300.00 
500.00 


200.00 


In  the  second  form  of  trial  balance,  shown  on  the 
opposite  page,  the  difference  between  the  two  sides  of 
each  account  is  drawn  off  to  determine  whether  or  not 
they  are  in  balance,  while  in  the  former  the  totals  of 
both  sides  are  used.  Either  method  is  correct,  but  the 
latter  is  perhaps  preferable. 

The  fact  is  that  a  trial  balance  is  not  an  absolute  proof 
of  correctness,  but  simply  a  proof  of  double  entry — that 
for  every  debit  there  exists  an  equal  credit  or  credits. 
The  accounts  might  be  greatly  in  error  and  yet  balance 
perfectly.  If  Cash  were  credited  and  Merchandise 
debited  for  $10.00  when  the  Proprietor  should  have  been 
debited,  the  trial  balance  will  not  necessarily  reveal  the 
mistake.  The  trial  balance  may  be  said  to  demand  equal 
debits  and  credits  and  to  have  no  concern  with  the  distri- 
bution or  location  of  those  debits  and  credits. 


26  Principles  of  Accounting 

ANALYSIS  OF  ACCOUNTS 

There  is  nothing  rigid  or  inelastic  about  accounts. 
They  may  be  created,  consolidated,  analyzed,  or  anni- 
hilated, according  to  the  needs  of  the  business.  If  any 
one  account  is  not  illuminating,  it  may  be  analyzed  into 
its  logical  parts  and  its  contents  transferred  to  several 
other  accounts.  The  old  account  then  may  be  balanced 
and  indicated  as  inactive  and  as  receiving  no  more  entries. 

Suppose,  for  example,  that  a  concern  owns  the  fol- 
lowing : 

Land  and  Factory  at  Chicago , $10,000.00 

Land  and  Factory  at  New  York 20,000.00 

Land  and  Factory  at  Boston 5,000.00 


Total    $35,000.00 


In  its  Ledger  it  has  one  account  as  follows : 

KEAL  ESTATE 


Jan.  1 $35,000.00 


On  July  15  it  desires  to  distinguish  between  the  property 
in  the  various  cities.  It  can  close  out  the  old  account 
and  substitute  for  it  three  new  accounts  as  follows : 

EEAL  ESTATE 


Jan.  1 $35,000.00 


$35,000.00 


July  15  E.E.— Chicago  (a)  $10,000.00 
15B.E.— N.  Y.  (b)  20,000.00 
15R.E.— Boston  (c)  5,000.00 


$35,000.00 


Bases  of  Accounting 

EEAL  ESTATE — CHICAGO 


27 


July  15  (a)  $10,000.00 


EEAL  ESTATE — NEW  YORK 


July  15 (b)  $20,000.00 


EEAL  ESTATE — BOSTON 


July  15 (c)   $5,000.00 


As  another  illustration  let  the  following  represent  a 
company's  Merchandise  Account: 

GENERAL  MERCHANDISE 


Jan.  1 , 

5, 

7, 

10 


$    600.00 

65.00 

110.00 

155.00 


15 211.00 

20 540.00 

25 308.00 

30 10.00 

$1,999.00 


Feb.  1     Balance $    709.00 


Jan.     3 $  500.00 

11 400.00 

21 22.00 

25 301.00 

27 67.00 

31     Balance..  709.00 


$1,999.00 


Suppose  that  on  February  2  it  is  decided  to  split  this 
account  into  its  several  components:  Hay,  $200.00; 
Grain,  $400.00;  Ground  Feed,  $109.00.  When  this  is 
done,  the  following  will  appear : 


28 


Principles  of  Accounting 


GENERAL  MERCHANDISE 


Jan 

1 

$    600.00 

Jan.     3   

$    500.00 

5               .  .    .  . 

65.00 

11  

400.00 

7 

110.00 

21  

22.00 

10  

155.00 

25  

301.00 

15 

211.00 

27  

67.00 

20  

540.00 

31     Balance* 

709.00 

25 

308.00 

30   

10.00 

$1,999.00 

$1,999.00 

Feb 

1     Balance1   .  . 

..    ..$    709.00 

Feb.  2     Hay   

.  (a)    $200.00 

2     Grain  . 

(b)     40000 

Ground  Feed. 

.(c)      109.00 

$    709.00 

$709.00 

H 

AY 

Feb. 

2.. 

..(a)   $200.00 

GRAIN 


Feb.  2 (b)  $400.00 


GROUND  FEED 


Feb.  2 (c)    $109.00 


1  The  operation  of  consolidating  a  number  of  debit  and  credit  items  in  an 
account  into  one  item  is  known  as  "transferring"  or  "forwarding  the  balance." 
It  is  an  operation  with  which  all  those  who  have  studied  bookkeeping  are  fa- 
miliar and,  therefore,  needs  no  description  in  this  volume.  Suffice  it  to  say  that 
it  consists  in  making  an  entry  on  the  smaller  of  the  two  sides  of  the  account 
sufficient  to  equal  the  opposite  total  and  thus  balance  it  and  in  then  ruling  a 
single  line  under  each  column,  which  is  followed  by  the  total  of  each  column. 
Under  the  total  is  ruled  a  double  line.  The  balancing  figure  is  then  forwarded 
to,  or  brought  down  on,  the  opposite  side.  It  requires  but  little  thought  to  see 
that  the  status  of  the  account  is  not  changed  in  the  least  by  this  procedure. 


Base*     f  Accounting  29 

•'s  ACCOUNT 

^ich  this  principle  of  subdivision 
.   oeen  most  thoroughly   applied  is   the 
;j,r'S. 

i'he  Proprietor's  Account  is  the  one  showing  the 
accountability  of  the  business  to  the  one  who  furnishes 
the  funds  with  which  to  conduct  the  business  and  who 
is  entitled  to  all  profits  and  is  responsible  for  all  losses. 
Whenever  a  profit  is  made,  it  must  in  the  end  be  credited 
to  the  account  representing  the  proprietor's  investment, 
as  in  a  sense  it  is  in  the  nature  of  a  special  liability  of 
the  business  to  him.  Whenever  a  loss  occurs,  it  is  debited 
to  the  Proprietor's  Account,  since  he  is  responsible  for 
all  losses.  A  valid  claim  against  the  proprietor  is  in  a 
similar  sense  in  the  nature  of  an  asset  of  the  business  as 
any  other  valid  claim  is  an  asset.  This  conception  of 
the  business  as  a  separate  entity  or  individuality  is 
particularly  appropriate  in  a  consideration  of  the  theory 
of  accounts.  It  is  sometimes  a  little  difficult  to  keep  this 
separate  individuality  in  mind,  especially  where  the 
proprietor  is  also  the  manager,  in  which  case  he  is  one 
individual  exercising  dual  functions.  These  two  func- 
tions should  be  kept  separate  and  distinct  as  an  aid  to 
any  analysis  of  accounting  principles  to  be  made. 

Inasmuch  as  the  business  has  an  existence  apart  from 
that  of  its  proprietor,  it  is  evident  that  the  relation 
between  the  two  is  a  matter  of  the  highest  importance. 
A  business  is  instituted  and  carried  on  with  one  end,  and 
only  one,  in  view.  This  ultimate  goal  is  profit.  That 
business  which  disregards  profit  cannot  long  endure,  and 
since  the  Proprietor's  Account  is  the  one  that  ultimately 
records  changes  resulting  in  profits  or  losses,  it  is  the 
most  important  of  all  accounts.  Proper  analysis  of  the 


30  Principles  of  Accounting 

Proprietor's  Account  is  of  the  greatest  importance.  And 
we  find  it  to  be  true  that  in  modern  accounting  practice 
scientific  analysis  and  classification  have  been  carried  to 
a  finer  point  here  than  in  any  other  account  or  set  of 
accounts. 

SUBSIDIARY  PROPRIETOR'S  ACCOUNT 

Very  few,  if  any,  concerns  are  so  simple  in  their  nature 
and  operation  as  to  find  a  single  Proprietor's  Account 
sufficient  for  their  needs.  Practically  every  business  is 
complex.  It  may  trade  in,  not  one  staple  article,  but 
numerous  articles.  It  has  not  half  a  dozen  items  of 
expense,  but  possibly  hundreds  or  thousands.  It  may 
be  composed  not  of  one  department,  but  of  several.  To 
manage  such  a  business  properly  requires  accurately 
classified  knowledge  for  administrative  guidance.  It  is 
not  sufficient  to  know  that  the  business  as  a  whole  is 
profitable.  The  manager  must  know  just  how  profitable 
each  department  or  other  subdivision  is.  If  he  does  not 
know  this,  how  can  he  feel  sure  that  his  organization 
is  not  composed  of  several  highly  profitable  departments 
and  one  or  two  very  unprofitable  ones  whose  elimination 
would  result  in  a  distinct  increase  in  total  profits?  If 
several  lines  of  merchandise  are  being  sold,  some  may 
be  contributing  large  profits,  and  some  actually  costing 
more  than  they  produce.  The  manager  must  know  these 
things,  and  he  can  get  them  in  but  one  way — from  the 
accounts  in  general  and  from  the  Proprietor's  Account 
in  particular.  In  order  that  this  vital  information  may 
be  yielded  by  the  Proprietor's  Account,  a  number  of 
carefully  selected  subsidiary  Proprietor's  Accounts  must 
be  brought  into  existence. 

For  example,  consider  a  small  department  store  with 


Bases  of  Accounting  31 

three  selling  departments.     It  would  be  proper  to  open 
ten  accounts  in  the  Ledger  as  follows : 

1.  Proprietor  for  Profits,  Dept.  1 

2  "  "         "  **      2 

3  "  "         "  "3 

4.  "  "  Expenses/ *      1 

5.  "  "         "  "      2 

6.  "  "         "  "      3 

7.  Merchandise,  Dept.   1 

8.  "  "        2 

9.  "  "        3 

10.  Proprietor's  Main  Account 

The  first  two  sets  of  accounts  are  pure  proprietorship 
accounts,  which  will  receive  the  entries  that  otherwise 
would  go  to  the  single  proprietorship  account  heretofore 
discussed.  The  nature  of  the  Proprietor's  Account 
remains  the  same,  but  its  structure  is  changed.  It  has 
been  separated  into  appropriate  parts.  There  still 
remains  a  single  so-called  "Proprietor's  Account"  (10 
in  above  list),  but  it  receives  its  entries  as  summaries  of 
the  data  contained  in  the  new  proprietorship  accounts 
(1  to  6  inclusive).  The  profit  for  a  given  period  for  a 
given  department  is  determined  by  combining  the  two 
accounts — Proprietor  for  Profits,  Dept.  1,  and  Proprietor 
for  Expenses,  Dept.  1.  This  final  figure  representing  net 
profit  is  then  transferred  to  the  main  Proprietor's 
Account,  and  the  other  two  proprietorship  accounts  are 
closed.  This  is  done  with  each  set  of  accounts  for  each 
department.  At  the  end  of  any  accounting  period  it  is 
possible  to  determine  the  profits  not  only  of  the  store 
as  a  whole  but  of  each  department  or  subdivision.  This 
principle,  outlined  only  crudely  so  far,  is  capable  of  the 


32  Principles  of  Accounting 

widest  application  and  is  the  very  foundation  of  modern 
accounting. 

There  will  ordinarily  be  a  separate  Proprietor's 
Account  for  each  distinct  class  of  expenses  or  losses, 
such  as : 

1.  Proprietor  for  Wages. 

2.  "  "  Bent. 

3.  "  "  Light. 

4.  "  "  Heat. 

5.  "  "  Interest. 

In  modern  practice  it  is  customary  to  drop  the  two 
words  "proprietor  for"  and  simply  speak  of  these 
accounts  as 


1.  Wages. 

2.  Rent. 

3.  Light. 

4.  Heat. 

5.  Interest. 


Many  have  difficulty  in  seeing  that  these  really  repre- 
sent assets  of  the  business  in  the  sense  that  they  are 
accounts  due  from  the  proprietor.  True,  the  proprietor 
seldom  pays  them,  because  the  business  usually  owes  him 
more  than  he  owes  the  business,  and  consequently,  the 
settlement  when  made  is  on  a  net  basis.  Hereafter,  in 
this  book,  when  we  speak  of  those  accounts  that  represent 
obligations  to  or  amounts  due  from  the  proprietor,  we 
will  use  the  names  which  they  habitually  bear  in  account- 
ancy, such  as  Bent,  Wages,  etc.,  and  not  the  more  cumber- 
some but  more  accurate  titles  of  Proprietor  for  Bent, 
Proprietor  for  Wages,  etc. 


Bases  of  Accounting  33 

NOMINAL  AND  EEAL  ACCOUNTS 

All  these  accounts  due  from  or  due  to  the  proprietor 
are  technically  known  as  "nominal  accounts"  to  dis- 
tinguish them  from  all  other  asset  and  liability  accounts 
which  are  called  "real  accounts." 

Every  nominal  account  may  be  said  to  have  been  "  split 
off"  from  the  original  Proprietor's  Account  with  which 
we  started,  and  the  results  shown  by  each  must  eventually 
find  their  way  back  to  the  main  Proprietor's  Account. 

DEVELOPMENT  OF  THE  MERCHANDISE  ACCOUNT 

We  have  seen  that  when  a  business  buys  merchandise, 
Merchandise  Account  is  debited  and  Cash  Account 
credited  and  that  when  merchandise  is  sold  at  an 
advanced  price,  Merchandise  Account  may  be  credited 
for  the  cost  price,  the  Proprietor  credited  for  the  profit, 
and  Cash  (or  Accounts  Eeceivable)  debited  for  the  total. 
This  is  a  theoretically  correct  proceeding,  but  there  are 
many  practical  objections  which  make  it  inadvisable. 
With  a  large  stock  of  rapidly  moving  merchandise 
acquired  under  varying  conditions  of  market,  it  is  diffi- 
cult, if  not  impossible,  to  obtain  the  true  cost  price  of 
each  sale,  nor  is  there  any  practical  advantage  gained 
by  doing  so. 

A  far  more  convenient,  simple,  and  economical  scheme 
is  to  debit  Merchandise  and  credit  Cash  (or  Accounts 
Payable)  for  the  cost  price  of  goods  purchased  and  to 
debit  Cash  (or  Accounts  Receivable)  and  credit  Mer- 
chandise for  the  selling  price  of  goods  sold.  Here  it  is 
obvious  that  an  inaccurate  record  has  necessarily  been 
made.  Goods  are  debited  to  Merchandise  on  one  basis — 
cost,  and  credited  to  Merchandise  on  another  basis — sell- 
ing price.  What  does  the  difference  between  the  debit 


34  Principles  of  Accounting 

and  the  credit  side  of  Merchandise  represent?  It 
represents  nothing.  There  is  an  element  of  profit  or  loss 
mixed  in  with  merchandise,  and  this  profit  or  loss 
properly  belongs  in  the  Proprietor 's  Account. 

INVENTORIES 

We  can,  however,  determine  the  facts  as  to  profit  or 
loss  at  any  given  time  by  an  inventory.  An  inventory 
consists  simply  of  a  physical  count  or  determination  of 
the  weight  of  articles  and  the  assignment  of  a  cost  value 
to  these  articles.  For  example,  suppose  that  100  bushels 
of  wheat  are  purchased  at  90  cents  a  bushel,  or  $90.00, 
that  sales  amount  to  $120.00,  and  that,  after  having  made 
those  sales,  the  inventory  shows  10  bushels  of  wheat  still 
on  hand  which  cost  90  cents  a  bushel,  or  $9.00.  How 
would  the  profit  be  determined?  In  the  first  place,  it  is 
necessary  to  know  how  many  bushels  of  wheat  were  sold 
and  what  the  cost  value  was.  If  100  bushels  are  pur- 
chased and  10  bushels  are  left,  90  bushels  must  have  been 
sold.  Each  bushel  cost  90  cents ;  therefore  the  total  cost 
of  the  goods  sold  is  90  X  90  cents,  or  $81.00.  Therefore 
$120.00  worth  of  goods  were  sold  that  cost  but  $81.00. 
$120.00  —  $81.00  =  $39.00  profit.  This  profit  can  then 
be  placed  to  the  credit  of  the  Proprietor's  Account  and 
represents  the  profits  on  all  wheat  transactions  for  the 
period.  This  is  more  efficient,  economical,  and  satis- 
factory than  laboriously  figuring  the  profit  on  each 
separate  sale,  and  yet  it  arrives  at  the  same  final  result. 
It  is  simply  a  short  cut  to  the  facts  existing  at  the  end 
of  the  accounting  period. 


Bases  of  Accounting 


MERCHANDISE 


35 


Jan.  1 

Purchases    

$  90.00 

Jan.   2     Sales   

$  30.00 

Gross    Profit    Trans- 

17       "      .... 

.  .      .     50.00 

ferred  to  Proprie- 

23       " 

19  00 

tor  's    Account  .  .  . 

39.00 

24        "       

7.00 

27        " 

14  00 

31     Inventory 

9  00 

$129.00 

$129.00 

Feb.  1 

Inventory   . 

$     9.00 

Note. — The  reader  will  observe  that  adding  inventory  on  the  credit  side 
is  equivalent  to  subtracting  it  from  the  debit  side.  Bookkeeping  technique 
forbids  making  deductions  in  accounts  but  prescribes  the  equivalent  of 
additions  on  the  opposite  side. 

MIXED  ACCOUNTS 

The  Merchandise  Account,  as  above  shown,  is  what  is 
known  as  a  "  mixed  account. "  A  mixed  account  is  one 
which  is  partly  real  and  partly  nominal.  Mixed  accounts 
are  not  looked  upon  with  favor  by  the  best  accountants, 
and  for  that  reason  they  are  being  used  less  and  less. 
There  is  no  necessity  for  any  mixed  accounts,  since  they 
may  be  easily  analyzed  into  their  component  parts,  or 
accounts,  which  are  either  wholly  real  or  nominal.  Thus, 
the  Merchandise  Account  above  shown  can  be  discon- 
tinued and  three  other  accounts  created  to  take  its  place. 
These  three  accounts  are : 

1.  Sales  Account. 

2.  Purchase  Account. 

3.  Inventory  Account. 

The  Sales  Account  is  credited  with  all  sales  at  selling 
price,  the  Purchase  Account  is  debited  with  all  purchases 
at  cost,  and  the  Inventory  Account  registers  the  result  of 
the  periodic  inventory.  The  profit  at  any  time  is  deter- 
mined by  adding  the  inventory  of  goods  on  hand  at  the 


36  Principles  of  Accounting 

beginning  of  the  period  to  the  total  purchases  made  and 
from  that  sum  deducting  the  final  inventory.  The  balance 
equals  the  cost  of  goods  sold,  and  the  difference  between 
it  and  the  balance  of  the  Sales  Account  represents  gross 
profit. 

For  example,  on  June  1, 1916,  there  were  goods  on  hand 
(determined  by  inventory)  of  $8,332.18.  Purchases  dur- 
ing June  amounted  to  $27,121.90.  Goods  on  hand,  June 
30,  1916  (determined  by  inventory),  amounted  to  $10,- 
883.38.  Total  sales  during  June  equaled  $27,115.99.  To 
determine  the  profit  for  June  the  following  calculation  is 
made: 

Total  Sales  in  June $27,115.99 

Inventory,  June  1 $  8,332.18 

Add — Purchases  during  June 27,121.90 


$35,454.08 
Deduct — Inventory,   June  30 10,883.38 


Cost  of  Goods  Sold 24,570.70 


Gross  Profit    $  2,545.29 

THE  ACCOUNTING  PERIOD 

With  the  simple  mechanical  contrivance  suggested  in 
the  early  part  of  Chapter  I  it  is  possible  to  determine 
the  condition  of  the  business  from  moment  to  moment. 
The  various  changes  since  made,  together  with  others  not 
yet  mentioned,  render  this  impractical,  if  not  impossible. 
We  must  be  satisfied,  therefore,  with  a  periodic  revelation 
of  the  business  condition.  This,  however,  is  not  a  serious 
drawback.  It  is  not  necessary  to  know  the  exact  facts 
hour  by  hour  or  day  by  day.  It  is  sufficient  to  obtain  them 
at  certain  regular  intervals.  The  regular  interval  for 
any  business,  be  it  a  month  or  a  year,  is  called  the  "ac- 
counting period." 


Bases  of  Accounting  37 

The  accounting  period  starts  with  all  the  nominal  or 
sub-proprietorship  accounts  in  balance,  with  the  excep- 
tion of  the  main  Proprietor's  Account.  During  the  ac- 
counting period  certain  changes  in  the  business  take 
place,  which  are  registered  in  the  accounts.  At  the  end 
of  the  period  the  balances  of  the  proprietorship  or  nomi- 
nal accounts  are  transferred  to  the  main  Proprietor's 
Account,  and  the  Ledger  is  then  ready  to  receive  entries 
for  the  next  accounting  period. 

BALANCE  SHEET  AND  PROFIT  AND  Loss  STATEMENTS 

The  end  of  every  complete  accounting  period  is  signal- 
ized by  two  operations :  the  preparation  of  a  statement 
of  profit  and  loss  and  the  preparation  of  a  balance  sheet. 
The  statement  of  profit  and  loss  is  simply  a  conventional 
recital  of  the  various  debits  and  credits  which  are  entered 
in  the  nominal  accounts  representing  losses  or  gains. 
This  statement  is  constructed  according  to  a  definite  plan 
and  is  a  classified  exhibit,  not  a  mere  list  or  schedule. 
The  balance  sheet  is  a  trial  balance  of  the  Ledger  after 
the  nominal  or  proprietorship  accounts  have  been  closed 
out  into  the  main  Proprietor's  Account.  It  is  a  trial 
balance  of  balances  and  not  of  totals,  and  it  is  taken  after, 
and  not  before,  the  nominal  accounts  have  been  consoli- 
dated. It  is  thus  a  list  of  the  balances  of  all  real  accounts 
in  the  Ledger,  or  a  list  of  the  assets  and  the  liabilities 
as  shown  by  the  records  (including,  of  course,  the  Pro- 
prietor 's  Account,  which  is  for  the  purpose  of  the  balance 
a  liability  and  which  itself  includes  the  balances  of  all  the 
nominal  accounts). 

The  functions  of  these  two  statements  are  now  plain. 
The  balance  sheet  shows  the  condition  of  the  business  at 
the  end  of  the  accounting  period.  It  is  like  a  photo- 
graphic snapshot,  since  it  gives  a  permanent  picture  of 


38  Principles  of  Accounting 

a  rapidly  changing  business  as  of  a  definite  moment  of 
time.  The  statement  of  profit  and  loss  fills  in  the  gap 
between  two  successive  balance  sheets,  explaining  the 
differences  existing  between  them  and  telling  the  story 
of  results  accomplished  by  the  transactions. 

It  has  been  said  that  accounting  has  only  two  principal 
objects  to  determine :  (a)  at  a  definite  period  the  financial 
position  of  the  business  and  (b)  the  causes  for  such  in- 
creases and  decreases.  The  first  function  is  that  of  the 
balance  sheet  and  the  second,  that  of  the  statement  of 
profit  and  loss. 

The  technical  preparation  of  these  statements  may 
well  be  left  for  treatment  in  a  later  chapter,  but  their 
importance  must  be  fully  appreciated  now.  Without 
them  the  book  records  of  a  business  would  be  almost 
valueless. 

The  length  of  the  accounting  period  is  not  essential. 
The  important  thing  is  that  these  periods  should  be  of  a 
uniform  length.  The  chief  use  of  any  kind  of  record  is 
for  comparison  and,  in  order  that  comparison  of  two 
statements  of  profit  and  loss  may  be  valuable,  they  must 
cover  the  same  standard  period.  The  most  commonly 
employed  unit  is  the  year,  although  many  concerns  now 
use  the  month.  The  objection  to  the  month  as  a  unit  is 
that  all  months  are  not  equal  in  time ;  some  months  con- 
tain four  and  some  five  Sundays,  some  months  have 
thirty-one  days  and  others  less.  A  somewhat  better  small 
unit  is  the  four  weeks'  period  and,  where  it  can  con- 
veniently be  employed,  it  is  coming  into  favor.  Likewise, 
for  comparative  purposes,  the  two  periodical  statements, 
the  statement  of  profit  and  loss  and  the  balance  sheet, 
should  be  uniform  in  structure  with  the  similar  state- 
ments of  other  periods. 


Bases  of  Accounting 


39 


THE  JOUKNAL, 

So  far,  the  Ledger  is  the  only  book  we  have  considered, 
and  as  a  matter  of  fact,  it  is  the  one  significant 
record  in  any  business.  It  can  be  seen,  however,  that 


FIG.  12. — The  Traditional  Journal  Form 

even  in  a  simple  business  appalling  inaccuracy  would  re- 
sult if  all  entries  were  made  directly  in  the  Ledger. 
Through  carelessness  errors  would  result  that  would 
disturb  the  balance — the  most  important  characteristic  of 
the  Ledger.  Through  the  inability  of  the  average  human 


40  Principles  of  Accounting 

mind  to  grasp  and  hold  a  complex  situation  compre- 
hensively, it  becomes  necessary  to  draw  up  a  memo- 
randum of  the  entries  before  actually  making  them  in 
the  Ledger.  The  figures  on  this  memorandum  may  be 
tested  for  " balance"  and  the  amounts  then  transferred 
to  the  Ledger  with  a  feeling  of  confidence  that  they  are 
correct.  This  memorandum  classifies  the  debits  and  cred- 
its and  furnishes  a  guide  and  authority  to  make  the  ledger 
entries.  It  is  really  an  order  to  the  ledger  clerk  to  make 
certain  entries.  If  permanently  kept,  it  affords  ready 
means  of  locating  errors  in  the  Ledger  should  that  book 
be  out  of  balance,  since  the  two  can  be  compared  for  dis- 
crepancies. Such  a  memorandum,  in  whatever  technical 
forms  it  may  be  kept,  is  a  Journal.  The  traditional 
Journal 2  is  a  blank  book  ruled  as  shown  in  Figure  12. 
The  extreme  right-hand  column  receives  all  figures  which 
are  to  be  credits  in  the  Ledger,  and  the  column  to  the 
left  of  it  receives  figures  which  are  to  be  debits  in  the 
Ledger.  Since  debits  and  credits  in  the  Ledger  must  be 
equal,  debits  and  credits  in  the  Journal  must  also  be 
equal.  Therefore,  a  test  is  obtained  by  adding  up  these 
two  journal  columns  and  comparing  the  totals,  which 
should  agree. 

POSTING 

The  operation  of  transferring  figures  from  the  Journal 
to  the  Ledger  is  known  as  "posting."  It  is  one  of  the 
rigid  rules  of  modern  bookkeeping  that  all  ledger  entries 
must  be  "posted"  and  never  made  direct.  When  this 
rule  is  in  force,  the  authority  for  any  entry  can  be  de- 
termined by  checking  it  back  against  the  Journal  (or 

2  The  Journal,  as  described  in  this  chapter,  is  pedagogically  very  im- 
portant, but  in  its  traditional  form  it  has  practically  disappeared  from 
modern  practice.  The  journal  function  still  remains,  however.  The  modern 
substitutes  for  the  Journal  will  be  described  at  length  in  Chapter  III. 


Bases  of  Accounting  41 

one  of  its  modern  substitutes).  This  rule,  of  course, 
does  not  apply  to  the  forwarding  of  balances,  which  in- 
volves no  new  entry. 

The  journal  entries  for  the  transactions  in  Figure  11 
might  appear  as  follows : 

1916 

June  2     Accounts  Payable   $  5.00 

Cash    $  5.00 

2     Cash   2.00 

Accounts  ^Receivable 2.00 

2     Cash    12.00 

Merchandise  10.00 

Ames    2.00 

2     Merchandise    5.00 

Accounts  Payable 5.00 

For  convenience  in  tracing  items  between  the  Journal 
and  the  Ledger,  it  is  customary  to  indicate  in  each  journal 
entry  the  page  of  the  Ledger  to  which  the  posting  was 
made  and  in  the  Ledger  Account  the  journal  page  from 
which  it  came. 

Modern  business  conditions  have  brought  about  a  sub- 
division of  the  Journal  into  special  journals  which  record 
only  particular  classes  of  facts.  Most  of  them  are  not 
called  journals  for  fear  of  confusing  them  with  the 
General  Journal,  which  still  is  used  to  handle  certain 
special  or  unusual  transactions  or  adjustment  entries 
which  cannot  be  conveniently  cared  for  otherwise.  The 
usual  journals  employed  in  nearly  every  business  are : 

The  Cash  Journals. 
The  Purchase  Journal. 
The  Sales  Journal. 
The  General  Journal. 

In  addition  to  these  four  there  are  other  journals  in 
common  use.  These  will  be  discussed  at  length  in  Chap- 
ter m. 


42  Principles  of  Accounting 

THE  CONTROLLING  ACCOUNT  AND  SUBSIDIARY  LEDGER 

So  far  in  our  discussion  we  have  only  hinted  at  the 
method  of  handling  two  of  the  most  important  accounts 
in  the  Ledger — Accounts  Eeceivable  and  Accounts  Pay- 
able. Accounts  Receivable  is  the  group  name  which  is 
applied  to  the  aggregate  of  amounts  which  others  owe 
to  us,  while  Accounts  Payable  is  the  group  name  for  the 
total  of  all  items  which  we  owe  to  others. 

Practically  all  modern  business  is  done  on  a  credit 
rather  than  a  cash  basis.  Nearly  all  the  customers  who 
come  into  a  store  purchase  goods  "on  account. "  The 
basis  of  credit  is  trust.  Those  trusted  customers  are 
permitted  to  purchase  goods  based  merely  on  their 
promise  to  pay  at  some  future  date.  Such  "promises  to 
pay"  are  assets.  Each  regular  customer  may  have  an 
account  in  the  General  Ledger  headed  with  his  name  and, 
when  sales  are  made  to  him,  his  account  is  charged  with 
the  amount  of  the  sale.  When  he  makes  payments,  his 
account  is  credited.  His  account  at  all  times  shows  the 
actual  amount  which  he  owes. 

Since  a  storekeeper  is  in  business  for  the  purpose  of 
merchandising,  and  the  better  storekeeper  he  is,  the  more 
merchandising  he  can  do,  it  follows  that  a  good  merchant 
may  have  a  large  number  of  such  customers'  accounts  in 
his  General  Ledger.  The  more  accounts  there  are  in  the 
General  Ledger,  the  more  chance  for  error  exists  and  the 
more  difficult  it  becomes  to  keep  the  Ledger  in  balance. 
The  remedy  for  this  situation  is  to  take  all  the  customers ' 
accounts  out  of  the  General  Ledger,  substituting  for  them 
a  single  account  entitled  "Accounts  Eeceivable. ' '  The  in- 
dividual customers '  accounts  may  be  bound  in  a  separate 
loose-leaf  ledger.  The  trial  balance  of  such  a  customers' 
ledger  should  show  a  net  figure  exactly  equal  to  the 


Bases  of  Accounting  43 

ance  of  the  Accounts  Eeceivable  Account  in  the  General 
Ledger. 

Such  an  Accounts  Receivable  Account  is  known  as  a 
"controlling  account."  A  controlling  account  is  a  sum- 
mary account,  which  receives  in  totals  the  debits  and 
credits  which  its  subsidiary  ledger  accounts  receive  in 
detail.  If  the  total  debits  to  various  customers '  accounts 
in  the  subsidiary  ledger  should  be  $10,000.00  during  a 
given  month,  then  the  Accounts  Eeceivable  Account 
should  be  charged  with  $10,000.00  in  one  lump  sum  at  the 
end  of  the  month.  If  the  sum  of  credits  to  individual 
customers '  accounts  is  $7,000.00  during  that  same  period, 
then  the  controlling  account  must  be  credited  with  $7,- 
000.00  in  a  lump  at  the  end  of  that  month.  The  manner 
of  handling  such  postings  is  discussed  in  a  later  chapter. 

CONTROL  ACCOUNTS  AND  DOUBLE  ENTRY 

The  important  point  to  note  is  that  the  General  Ledger 
is  complete  in  itself.  As  many  entries  as  desired  may  be 
made  in  the  subsidiary  records  without  affecting  the 
General  Ledger  in  the  least.  The  double  entry  system 
revolves  around  the  General  Ledger  as  its  unit  and,  in  a 
certain  sense,  has  no  concern  with  any  other  book.  As 
long  as  the  General  Ledger  balances,  we  have  double 
entry  regardless  of  any  supporting  schedules,  analytical 
records,  or  subsidiary  ledgers. 

OTHER  CONTROLLING  ACCOUNTS 

In  addition  to  the  Accounts  Receivable  Account  there 
are  several  other  controlling  accounts  commonly  em- 
ployed. The  various  creditors'  accounts  are  usually 
kept  in  a  subsidiary  ledger  and  controlled  by  an  Accounts 
Payable  Account  in  the  General  Ledger.  The  Notes 
Receivable  Account  and  the  Notes  Payable  Account  are 


44  Principles  of  Accounting 

often  controlling  accounts.  The  former  controls  the 
notes  themselves,  and  its  balance  must  agree  with  the 
unpaid  notes  on  file  or  on  hand  in  the  depository.  The 
Notes  Payable  Account  controls  a  memorandum  record 
known  as  a  "  Notes  Register.  "3 

In  conclusion,  a  controlling  account  is  one  which  is 
supported  by  subsidiary  detailed  records.  The  informa- 
tion appears  in  totals,  showing  in  one  aggregate  amount 
the  net  balance  of  its  subsidiary  accounts.  Controlling 
accounts  are  almost  universally  employed  in  modern 
business  and,  as  a  matter  of  fact,  the  General  Ledger  of  a 
large  corporation  may  consist  almost  entirely  of  control 
accounts. 

INCOMPLETE  DOUBLE  ENTRY 

Were  it  not  for  the  fact  that  the  C.  P.  A.  examina- 
tions of  the  various  states  sometimes  ask  questions  re- 
garding "incomplete  double  entry "  or  " single  entry, " 
as  it  is  often  called,  it  would  hardly  be  necessary  to  do 
more  than  mention  the  subject  in  this  book.  Very  few 
large  business  houses  use  anything  but  double  entry  in 
these  modern  days. 

The  distinguishing  feature  of  single  entry  is  its  per- 
sonal character.  It  generally  keeps  accounts  with  per- 
sons and  not  with  forces  or  things.  It  is  the  double  entry 
system  with  property  accounts  and  the  various  non-per- 
sonal liability  accounts  eliminated. 

It  is  clear  that  this  incompleteness  renders  it  incapable 
of  proof  by  balance.  This  reason  alone  is  sufficient  argu- 
ment against  its  use.  Furthermore,  no  profit  and  loss 
statement  can  be  prepared  from  the  books,  since  nominal 
accounts  are  not  kept.  No  balance  sheet  can  be  prepared 

3  Discussion  of  other  controlling  accounts  will  appear  in  following  chap- 
ters in  connection  with  the  several  subjects  as  they  are  reached. 


Bases  of  Accounting  45 

since  a  balance  sheet  is  fundamentally  a  post-closing  trial 
balance  of  the  General  Ledger;  but  a  substitute  for  the 
balance  sheet  may  be  prepared  by  taking  a  physical  in- 
ventory of  all  property  owned  and  of  all  liabilities  and 
by  listing  the  amounts  so  determined  in  balance  sheet 
form,  the  difference  between  the  assets  and  liabilities 
representing  the  proprietor's  interest  in  the  business. 
This  exhibit  is  called  a  "statement  of  resources  and  lia- 
bilities/' 

A  comparison  of  two  successive  statements  of  re- 
sources and  liabilities  will  afford  some  information  as 
to  the  events  that  took  place  between  the  two  dates.  A 
comparison  of  the  figures  on  such  statements  will  indicate 
the  net  gain  or  loss  of  the  period,  if  all  withdrawals  or 
additional  investments  have  been  taken  into  considera- 
tion. 

These,  at  best,  are  clumsy  expedients,  and  single  entry 
has  no  place  in  modern  accounting,  although  it  is  still 
found  in  use  with  some  smaller  business  houses,  particu- 
larly in  the  rural  districts. 

The  accountant  should  know  how  to  change  a  set  of 
books  from  incomplete  double  entry  (or  single  entry)  to 
complete  double  entry.  The  solution,  in  theory,  is  com- 
paratively simple — to  make  complete  what  is  incomplete 
something  must  be  supplied,  that  which  is  missing  must 
be  furnished.  Therefore,  the  various  non-personal  ac- 
counts must  be  added  to  the  single  entry  system  to  obtain 
the  double  entry.  The  method  of  doing  this  is  to  prepare 
a  statement  of  resources  and  liabilities  and  to  use  this 
statement  as  the  basis  of  a  journal  entry.  Since  the  per- 
sonal accounts  are  already  in  the  Ledger,  it  is  not  neces- 
sary to  post  them,  but  all  the  other  items  are  posted,  and 
the  Ledger  is  then  on  a  double  entry  basis. 


46  Principles  of  Accounting 

POSITIVE  AND  NEGATIVE  INVENTORIES 

We  have  discussed  very  briefly  the  use  of  a  physical 
inventory  in  connection  with  the  old-fashioned  Merchan- 
dise Account.  An  inventory  consists  of  a  physical  count 
(or  measurement  of  volume  or  weight)  of  articles  (or 
materials)  together  with  their  valuation.  It  is  employed 
to  correct  a  mixed  account  containing  both  real  and  nomi- 
nal elements,  its  use  being  by  no  means  confined  to  the 
Merchandise  Account.  For  instance,  assume  a  business 
having  an  accounting  period  of  one  year  extending  from 
the  first  day  of  January  to  the  last  day  of  December. 
The  management  insures  the  buildings  and  pays  a  pre- 
mium of  $100.00,  the  protection  to  cover  a  period  of  two 
years.  Insurance  may  be  considered  as  an  expense,  in 
which  case  the  following  entry 4  will  be  made : 

1915 

Jan.  1     Insurance  (a  nominal  account) $100.00 

Cash    $100.00 

On  December  31  the  books  are  closed,  and  the  balances 
of  all  nominal  accounts,  among  which  is  the  Insurance 
Account,  are  transferred  into  the  Proprietor's  Account. 
This  $100.00  spent  for  insurance  is  a  loss — an  expense — 
and  serves  to  reduce  the  amount  of  profits.  On  December 
31  of  the  next  year  there  will  be  no  insurance  item  to  take 
into  consideration  before  determining  profits.  Because 
the  insurance  was  paid  for  in  advance,  the  first  year  must 
bear  the  entire  burden  and  the  second  year  none,  although 
the  benefit  applies  equally  to  both  years.  We  see,  there- 
fore, that  the  profits  of  the  first  year  have  been  "robbed" 

*  This  entry  would  ordinarily  be  made  through  the  Cash  Journal  (or  the 
Cash  Book,  as  it  is  usually  designated),  but  in  this  case  as  in  others  hereafter, 
we  shall  indicate  the  entry  as  though  it  were  a  general  journal  entry.  This 
is  customary  among  accountancy  writers,  and  we  shall  conform  to  the  estab- 
lished practice. 


Bases  of  Accounting  47 

for  the  benefit  of  the  second  by  the  amount  of  one-half 
the  premium,  or  $50.00.  The  results  for  each  year  are 
untrue,  and  no  fair  comparison  can  be  made  between 
them.  This  can  be  plainly  seen,  since  it  is  apparent  that 
the  business  might  possibly  have  entered  into  an  agree- 
ment with  the  Insurance  Company  to  make  yearly  pay- 
ments. In  this  case  $50.00  would  have  been  debited  to 
Insurance  and  absorbed  by  the  Proprietor's  Account  the 
first  year  and  another  $50.00  the  second  year,  thus  mak- 
ing a  fair  and  equitable  division  between  the  two  periods. 
It  is  obvious,  however,  that  cash  payments  cannot  always 
be  arranged  in  this  convenient  way.  The  device  which 
is  used  in  such  cases  is  the  inventory.  If  the  business  dis- 
burses $100.00  for  insurance  the  first  year,  we  have  seen 
that  the  following  entry  is  made : 

1915 

Jan.  1     Insurance  (a  nominal  account) $100.00 

Cash    $100.00 

At  the  end  of  the  year  an  inventory  is  taken  of  the 
insurance,  and  when  it  is  found  that  half  of  the  protection 
has  been  used  up  and  that  half  of  it  is  still  available  for 
another  year,  the  following  journal  entry  is  made : 

1915 

Dec.  31     Unexpired  Insurance  (a  real  account) $50.00 

Insurance    (a  nominal  account) $50.00 

After  this  entry  the  balance  of  the  Insurance  Account 
is  only  $50.00,  which  is  transferred  to  the  Proprietor's 
Account. 

At  the  end  of  the  next  year  an  inventory  of  unexpired 
insurance  develops  that  no  more  protection  is  due  on  the 
policy.  The  asset  of  unexpired  insurance  is  non-existent 
and  must  be  written  off.  Posting  of  the  following  journal 
entry  accomplishes  this  purpose : 


48  Principles  of  Accounting 

1916 

Dec.  31     Insurance  (nominal  account) $50.00 

Unexpired  Insurance   (real  account) $50.00 

The  balance  of  Insurance  may  then  be  transferred  to 
the  Proprietor's  Account. 

There  are  two  ways  of  handling  accounts  which  are 
partly  asset  and  partly  expense.  One  way  is  to  remove 
the  asset  elements,  leaving  a  true  expense  account.  The 
other  is  to  remove  the  expense  element,  leaving  a  true 
asset  account.  Either  method  is  absolutely  proper. 
Thus,  in  the  example  just  mentioned,  either  of  the  two 
following  entries  would  have  been  made  at  the  end  of  the 
first  year: 

(a) 
1915 

Dec.  31     Unexpired  Insurance   (asset) $50.00 

Insurance  (mixed)    $50.00 

(The  Insurance  Account  being  left  wholly  "expense") 

(b) 

1915 

Dec.  31     Expired  Insurance   (expense) $50.00 

Insurance  (mixed)    $50.00 

(The  Insurance  Account  being  left   wholly   "asset") 

The  principle  involved  in  this  discussion  is  that  an 
expenditure  should  be  justly  distributed  over  the  ac- 
counting periods  benefited.  Thus,  if  the  insurance  pro- 
tection lasts  two  years,  the  expense  incurred  should  bear 
equally  upon  those  of  two  years.  This  involves  treating 
the  expense  as  an  asset  which  will  expire  as  time  passes. 
It  appears  on  the  balance  sheet  as  an  asset,  i.  e.,  Unex- 
pired Insurance,  but  it  is  not  a  permanent  asset  and  with 
the  passage  of  time  finds  its  way  into  the  nominal  ac- 
counts. Such  assets  are  known  as  "Deferred  Assets," 
"Deferred  Debits,"  or  "Deferred  Charges." 


Bases  of  Accounting  49 

LIABILITY  INVENTORIES 

In  addition  to  the  asset  inventories  discussed  in  the 
foregoing  section,  there  are  also  liability  inventories. 
The  purpose  of  such  inventories  is  also  to  equalize 
charges  over  two  or  more  accounting  periods.  For  ex- 
ample, at  the  end  of  a  given  accounting  period  it  may  be 
noted  that  a  certain  portion  of  the  year's  taxes  have 
accrued  but  have  not  yet  been  paid.  Suppose  experience 
shows  that  the  year 's  taxes  will  be  $120.00,  payable  at  the 
end  of  the  tax  year.  The  period  for  which  the  tax  will 
be  assessed  may  not  coincide  with  the  concern's  account- 
ing period ;  wherefore,  part  of  the  $120.00  is  chargeable 
to  one  accounting  period  and  the  balance  to  the  next.  If 
two  months '  taxes  were  chargeable  to  the  first  period,  an 
entry  would  be  made : 

Taxes  (expense)    $20.00 

Taxes  Payable  Accrued   (liability) $20.00 

The  item  of  taxes  would  then  be  absorbed  in  the  Proprie- 
tor's Account  for  the  current  accounting  period,  while 
the  item  of  taxes  payable  accrued  would  appear  as  a 
liability  on  the  balance  sheet  and  would  be  cared  for  in 
the  subsequent  accounting  period  when  the  taxes  are 
actually  paid. 

As  another  illustration,  suppose  wages  have  accrued  at 
the  end  of  the  period.  If  wages  are  payable  every 
Saturday  and  the  end  of  the  accounting  period  falls 
on  Wednesday,  the  wages  for  Monday,  Tuesday,  and 
Wednesday  will  not  have  been  paid.  For  these  three 
days  they  might  amount  to  $800.00.  To  set  this  item 
up  as  an  accrued  liability  and  to  insure  that  the  proper 
period  bears  the  burden,  the  following  entry  is  made : 

Wages    (expense)    $800.00 

Accrued  Wages  Payable   (liability) , ? $800.00 


50  Principles  of  Accounting 

The  item  of  wages  $800.00,  together  with  the  balance 
of  the  Wages  Account,  is  absorbed  by  the  Proprietor's 
Account,  and  the  item  of  accrued  wages  payable  appears 
as  a  liability  on  the  balance  sheet. 

If  such  asset  and  liability  inventory  adjustments  are 
not  made  at  the  end  of  an  accounting  period,  it  is  clear 
that  the  accidental  circumstances  of  payment  or  non- 
payment of  cash  will  affect  the  profits  of  the  period  either 
favorably  or  unfavorably.  Either  is  undesirable,  since  a 
distorted  and  untrue  picture  of  affairs  of  the  business  is 
thus  given. 

CONCLTJSION 

A  discussion  of  technique  is  not  desirable  in  a  work  on 
accounting  principles,  since  these  things  pertain  princi- 
pally to  the  art  of  bookkeeping.  We  have,  therefore,  not 
made  an  attempt  to  go  into  these  matters.  The  actual 
methods  of  consolidating  the  balances  of  nominal  accounts 
with  the  Proprietor's  Account  should  be  understood  by 
the  reader  before  studying  this  text.  Suffice  it  to  say 
that  journal  entries  are  made  which  debit  all  nominal 
accounts  which  have  credit  balances  and  credit  all  nomi- 
nal accounts  which  have  debit  balances,  the  contra  entries 
going  to  an  intermediate  proprietorship  account  usually 
called  the  "Profit  and  Loss  Account."  The  balance  of 
this  Profit  and  Loss  Account,  representing  a  profit  or  a 
loss,  is  then  by  a  journal  entry  transferred  to  the  Pro- 
prietor's Account. 

We  have  now  seen  that,  because  of  the  structure  of  the 
human  mind,  man  requires  symbols  or  representations  of 
complex  things  in  order  that  they  may  be  thereby  brought 
within  his  comprehension.  The  symbol  of  the  balance 
is  the  one  used  to  represent  the  business.  Its  funda- 
mental characteristic  is  its  balancing  feature,  and  from 


Bases  of  Accounting  51 

this  comes  the  double  entry  rule — the  law  of  debits  and 
credits.  The  business  is  represented  or  symbolized  by  a 
collection  of  accounts,  which  are  combined  into  the  Gener- 
al Ledger.  Changes  in  the  business  are  reflected  in  that 
ledger  by  appropriate  debit  and  credit  entries,  which 
theoretically  may  be  made  directly  to  the  accounts  af- 
fected, but  which  for  various  practical  reasons  are 
"posted"  from  the  Journal  (or  one  of  its  modern  substi- 
tutes). The  balance  of  this  Ledger  is  tested  by  a  device 
called  "the  trial  balance."  The  Ledger  represents  as 
debits  the  assets  of  the  business  and  as  credits  the  liabili- 
ties of  the  business.  The  liabilities  for  practical  purposes 
are  divided  into  liabilities  to  the  proprietor  and  liabilities 
to  others,  the  Proprietor's  Account  normally  showing  a 
credit  balance  but  receiving  debit  entries  for  all  ex- 
penses and  losses.  The  proprietor  is  responsible  for  all 
losses;  hence  they  are  in  a  technical  sense  assets  of  the 
business — an  account  receivable  from  the  proprietor. 
The  proprietor  is  entitled  to  all  profits;  hence  they  are 
technically  liabilities  of  the  business  to  the  proprietor — 
an  account  payable  to  the  proprietor. 

For  purposes  of  analysis  a  great  many  separate  pro- 
prietor's accounts  are  usually  used,  each  one  receiving 
only  certain  kinds  of  entries,  but  the  balances  of  these 
proprietorship,  or  nominal,  accounts  are  periodically 
transferred  to  some  intermediate  proprietor's  account 
where  the  net  result,  whether  a  gain  or  a  loss,  is  deter- 
mined. These  periods  are  known  as  "accounting 
periods"  and  should  be  uniform  for  comparative  pur- 
poses. Because  the  results  of  successive  accounting 
periods  are  compared  with  each  other,  it  is  essential  that 
one  period  be  not  unfairly  favored  at  the  expense  of 
another,  that  expenses  and  gains  be  recorded  in  the 
periods  during  which  incurred  or  earned.  This  has 


52  Principles  of  Accounting 

given  rise  to  expense  and  liability  inventories — Deferred 
Debit  Items  and  Deferred  Credit  Items  as  they  are  some- 
times technically  called. 

At  the  end  of  every  accounting  period  two  main  exhib- 
its are  prepared — the  statement  of  profit  and  loss  and 
the  balance  sheet.  The  latter  shows  the  balances  of 
the  ledger  accounts  at  a  definite  moment  of  time;  the 
former  presents  in  a  systematic  way  a  summary  of  the 
debits  and  credits  made  to  the  various  nominal  or  pro- 
prietorship accounts  during  the  accounting  period. 

TEST  QUESTIONS 

1.  What  is  the  Ledger? 

2.  What  is  the  relation  of  the  proprietor  to  the  business? 

3.  Why  is  a  trial  balance  of  balances  as  good  as  a  trial  bal- 
ance of  totals  in  testing  for  completeness  of  record? 

4.  What  is  the  fundamental  distinction  between  real  and 
nominal  accounts? 

5.  What  are  the  elements  of  the  mixed  merchandise  account? 


CHAPTER 

DEVELOPMENT   OF  THE   SPECIAL  JOURNALS 

In  the  preceding  chapter  we  found  that  a  business  is 
symbolized  or  represented  by  a  collection  of  accounts  in 
a  record  which  is  called  "the  Ledger "  and  that  current 
changes  in  the  business  are  reflected  by  changes  in  the 
general  ledger  accounts.  The  method  of  showing  such 
changes  in  the  Ledger  is  called  "making  ledger  en- 
tries. "  In  an  ideally  simple  business  requiring  only  a 
few  simple  accounts,  these  entries  might  be  made  directly 
in  the  Ledger,  but  the  complexity  of  modern  business 
renders  such  procedure  absolutely  impossible,  and  it  is 
now  universally  the  custom  to  make  a  formal  preliminary 
memorandum  of  each  ledger  entry.  This  memorandum 
acts  as  an  order  on  the  ledger  clerk  to  make  certain  en- 
tries and  should  be  permanently  retained,  since  it  may 
be  desirable  at  any  time  to  investigate  the  authority  for 
the  entries.  Such  a  collection  of  memoranda  is  called  ' '  a 
Journal. ' ' 

FUNCTION  OF  THE  JOTJKNAL 

The  modern,  inflexible  rule  of  bookkeeping  is  that  no 
ledger  entry  shall  be  made,  unless  it  is  posted  from  a 
record  performing  the  function  of  a  journal. 

The  Journal  classifies  all  business  transactions  into 
debits  and  credits,  and  from  it  the  debit  and  credit  figures 
are  posted  to  the  appropriate  debit  or  credit  sides  of  the 
specified  ledger  accounts.  The  number  of  the  ledger  page 

53 


54 


Principles  of  Accounting 


is  then  shown  on  the  Journal  in  the  space  provided, 
called  "the  folio  column/'  and  the  number  of  the  journal 
page  is  also  shown  on  the  Ledger,  thus  facilitating  cross 
references. 

Example:  June  1,  1916,  John  Smith  bought  merchan- 
dise on  account  from  Arthur  Eamsey  amounting  to 
$20(XOO.  June  1,  John  Smith  gave  his  note  for  $150,00  @ 
6%  to  Arthur  Eamsey  in  part  payment  of  the  account. 
June  30,  John  Smith  paid  the  note,  the  interest,  and  the 
balance  of  the  open  account  in  cash,  less  discount  of  \% 
on  the  open  account. 


1916 
June 


June    1 


June  30 


JOURNAL — JOHN  SMITH 

Merchandise  Purchases    (a)   $200.00 

Accounts  Payable  (a)  $200.00 

(Arthur  Eamsey — $200.00)  1 
Accounts  Payable  (b)     150.00 

(Arthur  Ramsey — $150.00)  1 

Notes  Payable (b)  150.00 

Accounts  Payable   (c)       50.00 

(Arthur  Eamsey — $50.00)1 

Notes  Payable  (c)     150.00 

Interest  Paid   (a)  .75 

Cash    (c)  200.25 

Purchase   Discounts    (c)  .50 


The  transactions  shown  above  in  journal  entry  form 
are  now  ready  for  posting  to  the  General  Ledger.  (The 
postings  to  the  subsidiary  Purchase,  or  Creditors',  Ledger 
need  not  be  illustrated  at  this  time.)  The  ledger  ac- 


1  The  items  in  parentheses  are  posted  only  to  the  subsidiary  Purchase  Ledger. 
This  Purchase  Ledger  has  Accounts  Payable  as  its  general  ledger  controlling 
account.  The  method  of  handling  controlling  accounts  illustrated  in  the  above 
journal  entry  is  not  in  ordinary  use,  since  certain  labor-saving  devices,  to  be 
explained  hereafter,  are  usually  employed. 


Development  of  Special  Journals 


55 


counts,  after  postings  from  the  above  journal  entries  have 
been  made,  appear  as  follows : 


MERCHANDISE  PURCHASES 


1916 

June  .1 (a)  $200.00 


ACCOUNTS  PAYABLE 


1916 

(b)  $150.00 

1916 

(a)  $200.00 

30.. 

.  .  (c}    50.00 

NOTES  PAYABLE 


1916 
June  30. 


(c)  $150.00 


1916 
June  1, 


(b)  $150.00 


INTEREST  PAID 


1916 
June  30 


(c)  $  .75 


PURCHASE  DISCOUNTS 


1916 
June  30. 


(c)  $  .50 


CASH 


1916 
June  30 


(c)  $200.25 


COLUMNAR  JOURNAL 

The  combination  of  a  single  Journal  and  a  General 
Ledger  (with  two  subsidiary  ledgers  for  recording  de- 


56  Principles  of  Accounting 

tails  of  Accounts  Eeceivable  and  Accounts  Payable)  is 
sufficient  to  handle  any  kind  of  business  transaction,  no 
matter  how  complex  it  may  be.  A  little  thought,  how- 
ever, will  show  that  there  will  be  a  great  many  transac- 
tions to  be  recorded  which  are  similar  in  nature,  although 
not  in  amount.  Even  in  a  small  business  there  will  be  a 
great  many  debits  and  credits  to  the  Cash  Account  during 
any  one  accounting  period ;  there  will  be  many  entries  to 
Merchandise  Purchases,  to  Merchandise  Sales,  to  Ac- 
counts Receivable,  and  to  Accounts  Payable  Accounts. 

It  would  be  perfectly  proper  in  the  case  of  cash  transac- 
tions to  post  day  by  day  from  the  Journal  to  the  Ledger 
all  debits  and  credits  except  those  to  the  Cash  Account ; 
at  the  end  of  the  month  the  bookkeeper  could  pick  out  of 
the  Journal  all  debits  to  Cash,  total  them  on  an  adding 
machine,  and  post  that  total  in  one  lump  sum  to  the  debit 
of  the  Cash  Account.  In  a  similar  way  he  could  pick  out 
all  journal  credits  to  Cash  and  post  the  total  to  the  credit 
of  the  Cash  Account.  If  there  were  fifty  debits  and 
credits  to  Cash  scattered  through  the  Journal,  the  book- 
keeper would  save  forty-eight  general  ledger  entries  by 
the  above  plan.  The  one  danger  to  be  feared  is  that  he 
will  overlook  one  or  more  items  in  arriving  at  his  total. 
This,  of  course,  would  throw  the  General  Ledger  out  of 
balance.  To  avoid  this  possibility  of  error,  two  extra 
columns  may  be  put  in  the  Journal,  one  headed  ' '  Cash- 
Dr."  and  the  other,  "Cash-Cr."  All  cash  items  will 
appear  in  these  special  columns  instead  of  in  the  regular 
debit  and  credit  columns.  At  the  end  of  the  month  the 
"Cash-Dr."  column  is  footed  and  the  total  posted  to  the 
debit  of  the  Cash  Account  in  one  lump  sum.  The  ' '  Cash- 
Cr."  column  is  also  footed  and  the  total  posted  to  the 
credit  of  the  Cash  Account. 

A  journal  page  in  simplest  form  is  shown  in  Figure  13, 


Development  of  Special  Journals  57 


S",ooo 


00 


(I) 


3,000 


3,000 


06 


fc) 


I.OOO 


U) 


5~00 


OC 


/,ooo 


00 


3.S-0 


Ztro 


(F 


/oo 


/oo 


00 


23 


00 


4  IS-o 


00 


FIG.  13. — Illustration  of  Transactions  Using  Regular  Journal  Form 
Compare  with  Fig.   14  for  a  better  method  of  handling  same  transactions. 


58 


Principles  of,  Accounting 


and  one  exactly  the  same,  except  that  all  cash  items 
are  segregated  as  explained,  in  Figure  14. 

John  Smith's  cash  account  after  posting  the  journal 
entries  shown  in  Figure  13  appears  as  follows : 


CASH— JOHN  SMITH 


1916 
June  1  

.  .  (a)    $5,000.00 

1916 
June  2  (b)   $3,000.00 

9 

(f)         250.00 

7                            (e)        980.00 

15 

.  .  (g)        900.00 

30    Balance  3,397.00 

18  

.  .  (h)        100.00 

30  

.  .  (k)     1,127.00 

$7,377.00 

$7,377.00 

July  31    Balance... 

..$3.397.00 

John  Smith's  cash  account  after  posting  journal  entries 
shown  in  Figure  14  appears  as  follows: 


CASH — JOHN  SMITH 


1916 
June    30. 


,$7,377.00 


1916 

June   30 $3,980.00 

30     Balance    3,397.00 

$7,377.00 


$7,377.00 
July    1    Balance $3,397.00 


It  can  easily  he  seen  that  this  is  a  great  labor-saver 
where  a  number  of  cash  items  appear  in  the  Journal.  It 
is,  of  course,  equally  labor-saving  when  used  with  other 
classes  of  items.  If  a  great  many  credit  sales  are  made, 
two  more  columns  may  be  added  to  the  four  already  in 
the  Journal.  One  of  these  may  be  headed  "Accounts 
Eeceivable-Dr. ' '  and  the  other, ' l  Merchandise  Sales-Cr. ' ' 
The  first  column  collects  all  amounts  debitable  to  Ac- 


Development  of  Special  Journals  59 


JOURNAL 


DATE 


EXPLANATION 


LF. 


CASH 


Dr. 


Cr. 


SUNDRY 


Dr. 


a. 


/,ooo 


',000 


f/P 


/  0  0 


7,377 


FIG.  14. — Dluatration  of  Transactions  Using  Columnar  Journal 
Compare  with  Fig.  13. 


60  Principles  of  Accounting 

counts  Eeceivable  Account  and  holds  them  until  the  end 
of  the  month,  at  which  time  the  total  only  is  posted.  In 
the  same  way  "Merchandise  Sales-Cr. ' '  collects  and  holds 
all  credits  for  the  Merchandise  Sales  Account  until  the 
end  of  the  month,  total  only  being  posted. 

A  similar  pair  of  columns  can  be  used  for  Merchandise 
Purchases  and  Accounts  Payable. 

Any  number  of  such  special  columns  may  be  employed, 
limited  only  by  the  size  of  the  Journal  Book,  which  should 
not  be  too  large  for  comfortable  handling. 

A  Journal  containing  special  columns  for  (1)  Cash, 
(2)  Accounts  Eeceivable,  (3)  Accounts  Payable,  (4)  Mer- 
chandise Purchases,  and  (5)  Merchandise  Sales,  together 
with  " general' '  columns  for  all  items  that  cannot  be 
"  lumped  "  into  any  of  the  above  five  classes,  will  be  ruled 
as  shown  in  Figure  15. 

You  will  note  that  the  method  of  posting  the  columnar 
totals  is  to  bring  them  into  the  '  *  general ' '  column.  There 
are  two  reasons  for  this:  (1)  A  test  of  balance  is  ob- 
tained by  footing  the  two  "general"  columns,  which 
should  be  equal  after  the  special  column  footings  have 
been  transferred  to  them,  and  (2)  it  is  in  accord  with  a 
good  rule  which  says  that  nothing  shall  be  posted  from  a 
columnar  journal  save  items  in  the  "general"  columns. 
Adherence  to  this  rule  prevents  errors. 

SPECIALIZED  JOUKNALS 

As  the  Journal  continues  to  expand  and  new  columns 
are  added,  the  book  becomes  unwieldy  and  difficult  to 
handle.  Furthermore,  as  the  business  grows,  the  transac- 
tions increase  to  a  number  greater  than  one  bookkeeper 
can  handle  and  yet  the  Journal,  so  far  as  we  have  now 
developed  it,  can  be  used  by  only  one  bookkeeper  at  a 
time.  What  is  more  natural,  under  these  circumstances, 


Development  of  Special  Journals 


61 


62  Principles  of  Accounting 

than  to  split  this  journal  into  two  separate  journals,  so 
that  two  men  can  work  at  one  time?  You  should  notice 
that  even  though  it  is  split  into  two  books  it  is  still  the 
same  journal  with  which  we  started.  There  is  a  physical 
difference,  but  not  a  difference  in  function. 

It  is  clear  that  little  or  nothing  will  be  accomplished 
by  making  the  two  new  journals  exact  duplicates  of  the 
original  journal,  since  each  would  still  have  too  many 
special  columns.  The  better  way  is  to  limit  one  of  the 
journals  to  recording  one  class  of  facts.  In  other  words, 
take  two  of  the  special  columns  away  from  the  original 
journal  and  make  a  new  journal  out  of  them.  In  a  busi- 
ness where  the  number  of  sales  on  credit  is  very  large, 
the  new  journal  might  be  called  the  " Sales  Journal/'  and 
its  use  would  be  confined  to  recording  sales  to  customers. 
(See  Figure  16.) 

During  the  month  the  individual  items  should  be  posted 
to  the  Customers'  Ledger  (a  subsidiary  ledger  controlled 
by  the  Accounts  Eeceivable  Account  in  the  General 
Ledger),  thus,  $383.75  would  be  debited  to  Myron  Van 
Gorder's  account  and  $30.30  would  be  debited  to  C.  F. 
Denison's  account.  At  the  end  of  the  month  the  total 
sales  $414.05  would  be  debited  to  Accounts  Eeceivable 
and  credited  to  Sales  in  the  General  Ledger.  You  will 
now  begin  to  perceive  how  the  controlling  account  and 
the  subsidiary  ledger  are  handled  in  actual  practice.  The 
subsidiary  ledger  is  posted  from  day  to  day,  and  the 
general  ledger  accounts  are  posted  at  the  end  of  the 
month  in  totals. 

The  regular  Journal  has  now  been  shorn  of  some  of 
its  importance,  since  all  sales  are  handled  through  a 
special  journal  reserved  for  the  purpose.  In  much  the 
same  way  we  may  use  a  Purchase  Journal  for  all  pur- 
chases from  others  on  credit.  This  journal  resembles 


Development  of  Special  Journals 


63 


the  Sales  Journal  in  appearance,  although  it  has  an  en- 
tirely different  function.  The  individual  purchases  are 
credited  to  the  individual  accounts  in  the  Creditors' 


SALES    JOURNAL 


DATE 


ACCOUNTS  DEBITED 


TERMS 


'EXTEN- 


TOTAL 


1$ 


/.IS" 


IS 


2$ 


30  30 


11, 


S'o 


.0  f 


00 


to 


(«),       .'32- 


12. 


?o 


-31 


05 
4/4  of 


FIG.  16. — Sales  Journal 

Ledger  (a  subsidiary  ledger  controlled  by  Accounts  Pay- 
able in  the  General  Ledger),  and  at  the  end  of  the  month 
the  total  is  debited  to  Purchases  and  credited  to  Ac- 


64 


Principles  of  Accounting 


counts  Payable  in  the  General  Ledger  in  one  lump  sum. 
(See  Figure  17.) 

If  the  reader  can  once  grasp  the  idea  that  the  Ledger 
is  complete  in  itself  and  independent  of  all  detailed  sub- 
sidiary records,  he  will  have  but  little  difficulty  in  under- 
standing even  the  most  complex  types  of  journals.  Each 


PURCHASE    JOURNAL 


DATE 


ACCOUNT  CREDITED 


/,  2,5-0    oo 


I/ 


3,7  & 


FIG.  17. — Purchase  Journal 

journal  must  act  as  the  basis  for  at  least  two  general 
ledger  entries  as  in  the  Sales  Journal  shown,  where  Ac- 
counts Receivable  was  debited  $414.05  and  Sales  Account 
was  credited  $414.05.  Two  other  entries  were  made  (to 
the  subsidiary  ledger)  from  the  Sales  Journal,  but  these 
in  no  way  affected  the  General  Ledger,  although  they 
aggregated  the  same  amount  that  is  charged  the  general 
ledger  control  account. 

Thus  we  see  that  the  modern  journal,  such  as  the  Sales 


Development  of  Special  Journals 


65 


Journal  or  the  Purchase  Journal,  has  at  least  two  func- 
tions. It  acts  as  a  posting  medium  for  the  General  Ledg- 
er, and  for  that  purpose  its  debits  and  credits  must  be 
equal.  It  also  acts  as  a  posting  medium  for  a  subsidiary 
ledger,  which  simply  furnishes  the  detail  of  one  general 
ledger  account.  Thus,  the  general  ledger  account  and  the 


CASH    RECEIPTS   JOURNAL 


DATE 


ACCOUNT  TO  BE  CREDITED 


LF. 


AMOUNT 


30 


00 


00 


FIG.  18. — Cash  Eeceipts  Journal 

subsidiary  ledger  "  check "  and  prove  each  other.  If 
there  is  any  discrepancy  between  the  two,  it  must  be 
traced  down,  since  it  indicates  the  existence  of  at  least 
one  error  in  posting. 

Another  important  class  of  transactions  which  may  be 
segregated  are  those  that  refer  to  cash.  One  journal  may 
be  reserved  for  cash  receipts  and  another  for  cash  dis- 
bursements. A  simple  form  of  Cash  Eeceipts  Journal  is 
shown  in  Figure  18. 


66 


Principles  of  Accounting 


During  the  month  the  various  general  ledger  accounts 
are  credited,  and  at  the  end  of  the  month  the  Cash  Ac- 
count is  debited.  No  provision  is  made  in  the  ruling 
of  this  Journal  for  postings  to  subsidiary  ledgers.  This 
can  be  remedied  by  inserting  another  column  in  this 
Journal  to  take  all  credits  to  Accounts  Eeceivable  con- 
trolling account. 


CASH    RECEIPTS    JOURNAL 


DATE 


EXPLANATION 


LF 


ACCOUNTS 
RECEIVABLE 
Cr. 


CASH 
Dr. 


SJ 


Oc 


Jo 


SO 


FIG.  19. — Columnar  Cash  Receipts  Journal 

In  regular  journal  form  the  general  ledger  entries  for 
the  transaction  shown  in  Figure  19  would  appear  as  fol- 
lows: 

Cash   $26L50 

Interest $     5.00 

Bent    30.00 

Interest    50 

Accounts  Eeceivable   226.00 

and,  in  addition,  the  following  credits  would  have  to  be 
made  in  the  subsidiary  Customers'  Ledger. 


Development  of  Special  Journals 


67 


Walter  Jones    $  45.00 

John  Dale 108.00 

Joseph  Smith 51.00 

Arthur   Brown    22.00 

The  Cash  Disbursements  Journal  may  be  in  the  simple 
form  like  the  first  Cash  Receipts  Journal,  but  preferably 
a  column  will  be  provided  to  receive  the  detailed  items 
which  make  up  the  lump  sum  charge  to  Accounts  Payable 
controlling  account. 


FIG.  20, — Cash  Disbursements  Journal 


68  Principles  of  Accounting 

Put  in  the  conventional  journal  form  shown  in  Figure 
20,  the  general  ledger  entry  to  be  made  would  appear  as 
follows : 

Labor    $  50.00 

Postage 5.00 

Express  Inward   13.50 

Carfare   25 

Accounts  Payable 304.92 

Cash    $373.67 

and,  in  addition,  the  following  debits  would  be  made  in 
the  subsidiary  Creditors'  Ledger. 

John  Simons   $  63.00 

Morris  Johnson 121.00 

Frederick  Hampton  87.62 

Charles  Morton 10.00 

Eichard  Sexton 23.00 

E.  C.  Herron 30 

In  a  business  of  sufficient  size  it  is  quite  satisfactory 
to  have  separate  journals  for  cash  receipts  and  cash 
disbursements,  but  the  proprietor  of  a  small  establish- 
ment often  desires  to  have  the  two  combined  into  one 
Cash  Journal.  No  change  in  the  arrangements  hitherto 
proposed  is  necessary,  except  that  in  the  combined  book 
the  left-hand  page  will  then  register  the  cash  receipts  and 
the  right-hand  page  will  register  the  cash  disbursements, 
as  shown  in  Figure  21. 

Many  bookkeepers  claim  that  when  the  Cash  Journal 
is  kept  in  this  form,  it  is  not  necessary  to  carry  a  General 
Ledger  Cash  Account  at  all — that  the  Cash  Journal  itself 
takes  its  place.  In  this  they  are  unquestionably  right. 
The  author,  however,  feels  that  very  little  is  gained 
thereby,  since  the  monthly  posting  of  totals  to  the  Cash 
Account  consumes  little  time  and,  if  it  were  omitted,  no 


Development  of  Special  Journals 


69 


CASH    JOURNAL 


DISBURSEMENTS 


13    * 


/; 


FIG.  21. — Cash  Journal  Which  Is  Used  Purely  as  a  Posting  Medium 
Compare  this  exhibit  with  Fig.  22. 


CASH    JOURNAL 


DISBURSEMENTS 


ACCOUNTS' 
FJW 
C,. 


ACCOUNTS 
YAI 

D, 


CASH 
C, 


FIG.  22. — Cash  Journal  Which  Is  Used  as  a  Posting  Medium  and  Which 

^4Zso  Serves  as  a  Cash  Account 
Such  an  exhibit  is  usually  known  as  a  "Cash  Book."     Compare  with  Fig.  21. 


70  Principles  of  Accounting 

complete  trial  balance  could  be  taken  from  the  General 
Ledger. 

A  Cash  Journal  which  will  take  the  place  of  the  Cash 
Account  is  shown  in  Figure  22.  Observe  that  the  totals 
of  the  cash  columns  are  not  posted,  but  that  the  two  sides 
are  balanced  and  that  the  cash  balance  is  carried  forward, 
just  as  it  is  in  a  ledger  account. 

Throughout  this  book  we  will  assume  that  a  Cash 
Account  is  carried  in  the  General  Ledger  and  that  the 
Cash  Journal  is  purely  a  posting  medium.  This  is  in 
accordance  with  the  best  accounting  theory  as  well  as 
good  practice. 

We  have  now  created  four  special  journals  for 


1.  Sales. 

2.  Purchases. 

3.  Cash  Receipts. 

4.  Cash  Disbursements. 


Thus  our  original  journal  is  relieved  of  most  of  its 
entries.  Through  these  special  journals  practically  all 
necessary  entries  to  the  Accounts  Receivable  and  the 
Accounts  Payable  Accounts  can  be  made,  although  the 
original  journal  still  handles  a  few  of  such  items,  for 
instance,  when  notes  are  given  or  received  or  special 
adjustments  made.  Instead  of  a  highly  columnarized 
book,  the  Journal  (Figure  23)  has  become  simple,  and 
only  a  few  entries  pass  through  it  monthly.  It  can  never 
be  entirely  dispensed  with,  however,  since  there  are 
always  many  special  items  which  can  be  handled  through 
no  other  medium. 

The  Accounts  Receivable  and  the  Accounts  Payable 
columns  are  retained  in  the  Journal  in  order  to  receiv 
the  occasional  debits  and  credits  affecting  these  accounts 


« 


Development  of  Special  Journals 


71 


These  entries  may  arise  from  allowances,  returns,  notes, 
and  other  sources. 

CASH  DISCOUNTS 

In  almost  every  business  it  is  customary  to  grant 
discounts  to  those  customers  who  pay  their  bills  promptly. 
The  discount  is  usually  a  percentage  of  the  total  invoice 


JOURNAL 


ACCOUNTS 

PAYABLE 

Dr. 


ACCOUNTS 
RECEIVABLE 
Dr. 


GENERAL 
Dr. 


GENERAL 
Cr. 


ACCOUNTS 
RECEIVABLE 
Cr 


ACCOUNTS 

PAYABLE 

Cr. 


FIG.  23. — Columnar  Journal  When  Used  as  a  Posting  Medium  for  Notes 
Received  and  Given 

price  f.  o.  b.  shipping  point,  and  is  only  allowed  to  cus- 
tomers if  they  make  payment  in  cash  within  a  definite 
time  from  the  date  of  shipment.  Such  a  discount  is,  in 
reality,  a  bonus  for  promptness  and  not  a  reduction  in 
the  selling  price,  although  many  people  are  confused 
into  thinking  so  because  it  is  a  percentage  of  the  sales 
price. 

The  method  of  booking  such  discounts  is  very  simple 
if  all  transactions  are  passed  through  the  original  jour- 


72  Principles  of  Accounting 

nal.    For  example,  we  ship  $1,000.00  worth  of  goods  to 
A.   S.  Morton  and  grant  him  the  privilege   of  a  2% 
discount  if  the  bill  is  paid  within  ten  days  from  date 
of  shipment. 
Journal  entry  made  at  time  of  sale : 

Accounts  Receivable  $1,000.00 

(A.  S.  Morton  $1,000.00) 
Sales    $1,000.00 

Journal  entry  when  bill  is  paid  and  discount  taken : 

Cash    $980.00 

Sale  Discounts  (nominal  account) 20.00 

Accounts  Receivable $1,000.00 

(A.  S.  Morton  $1,000.00)  ^ 

On  the  other  hand,  suppose  that  we  bought  $500.00 
worth  of  goods  from  Kiley  &  Co.  on  the  same  terms.  At 
the  time  of  the  purchase  we  would  make  the  following 
journal  entry: 

Merchandise  Purchases    $500.00 

Accounts  Payable $500.00 

(Riley  &  Co.  $500.00) 

When  we  pay  the  bill  and  take  the  discount,  we  will  make 
a  journal  entry  as  follows : 

Accounts  Payable  $500.00 

(Riley  &  Co.) 

Cash    %. $490.00 

Purchase  Discounts  (nominal  account) 10.00 

If  many  such  transactions  occurred,  we  might  adopt 
the  columnar  expedient  in  the  Journal:  one  column 
headed  " Sales  Discounts — Dr."  and  the  other  "Purchase 
Discounts — Cr. ' ' 

How  shall  purchases  and  sales  discounts  be  recorded 
in  the  system  where  several  journals,  instead  of  one,  are 
employed? 


Development  of  Special  Journals 


73 


It  is  clear  that  they  may  be  handled  through  a  special 
column  in  the  Journal,  but  since  they  are  intimately 
associated  with  receipts  from  customers  and  payments 
to  creditors,  which  are  handled  through  the  Cash  Eeceipts 
Journal  and  the  Cash  Disbursements  Journal  respec- 
tively, it  is  plain  that  economy  and  efficiency  will  not 
result  from  such  a  plan.  A  complete  transaction 
including  credit  to  Accounts  Receivable  and  debits  to 
Cash  and  Sales  Discounts  should  be  made  through  one 


CASH    RECEIPTS   JOURNAL 


DATE 


EXPLANATION 


FOLIO 


Dr. 


ACCOUNTS 
RECEIVABLE 

Cr. 


CASH 
Dr. 


3.7$- 


11 


/  12. 


/S 


Z2 


FIG.  24. — Cash  Eeceipts  Journal,  Showing  Method  of  Handling  Sales 

Discounts 

If  put  in  conventional  journal  entry  form  it  would  appear  as  follows : 

Sales  Discounts   $      56.48 

Cash     3,247.54 

Rent — 14th    St.    Property $    275.00 

Interest    Earned    .46 

Accounts   Receivable   3,028.56 


74 


Principles  of  Accounting 


journal,  and  that  one  will  naturally  be  the  Cash  Receipts 
Journal. 

The  entire  transaction  of  paying  an  account  and  taking 
the  discount,  involving  a  debit  to  Accounts  Payable  and 
credits  to  Cash  and  Purchase  Discounts,  should  be  made 
through  the  Cash  Disbursements  Journal.  The  two  Cash 
Journals  in  revised  form  will  then  appear  as  in  Figures 
24  and  25. 


CASH    DISBURSEMENTS   JOURNAL 


DATE 


EXPLANATION 


L.F 


CHECK 


PURCHASE 
DISCOUNT 
Cr. 


ACCOUNTS 

PAYABLE 

Pr. 


CASH 
Cr. 


f-,3.00  oo 


/.Zoo 


IS 


772. 


WO 


£65- 


IO 


13 


ft* 


/7o 


2s- 


S83 


32? 


09 


6-3 


2./Z2 


3/ 


a*. 


—    C^-tX 


72 


S.762 


&.S23 


FIG.  25. — Cash  Disbursements  Journal,  Showing  Method  of  Handlin 
Purchase  Discounts 

Putting  it  in  journal  entry  form  we  get  the  following : 

Drayage   and    Hauling $      15.00 

Wages  Payable 772.87 

Interest   Lost   10.21 

Accounts  Payable    5,762.58 

Purchase   Discounts    $      36.72 

Cash     6,523.94 


Development  of  Special  Journals  75 

This  method  of  handling  purchases  and  sales  discounts 
is  simple.  Its  chief  disadvantage  is  that  it  introduces 
non-cash  items  into  the  Cash  Journals,  but  this  is  a  matter 
of  small  moment  compared  with  the  convenience  and 
efficiency  that  result  from  such  treatment.  Strictly 
speaking,  the  Cash  Journal  should  receive  only  such 
entries  as  refer  to  the  receipt  or  the  disbursement  of 
cash,  a.nd  discounts,  either  purchase  or  sale,  are  not  cash 
items,  but  refer  to  allowances  or  premiums  for  prompt- 
ness in  paying.  When  a  customer  pays  $980.00  in  cash 
as  full  payment  for  a  $1,000.00  account,  the  transaction, 
upon  analysis,  appears  as  follows: 

Cash  $980.00 

Accounts  Eeceivable $980.00 

Sales  Discount  20.00 

Accounts  Eeceivable 20.00 

In  the  second  entry,  no  cash  transaction  occurred,  and 
since,  by  definition,  the  Cash  Journals  receive  only  such 
items  as  refer  directly  to  cash  receipts  or  to  cash  disburse- 
ments, it  is  clear  that  purchases  and  sales  discounts  do 
not,  by  nature,  belong  in  these  two  journals.  To  repeat, 
however,  it  is  a  matter  of  economy  and  efficiency  to  pass 
such  discounts  through  the  Cash  Journals,  and  practically 
all  accountants  do  so. 

NOTES  AND  BILLS  JOURNALS 

In  a  business  where  the  number  of  notes  given  or 
received  is  small,  it  is  customary  to  pass  them  through 
the  Journal  in  the  same  way  that  other  infrequent  entries 
are  made,  but  where  a  large  volume  of  note  transactions 
occur,  it  is  better  to  have  special  journals  for  handling 
them.  These  journals  are  the  Notes  and  Bills  Eeceivable 
Journal  and  the  Notes  and  Bills  Payable  Journal.  These 


76 


Principles  of  Accounting 


are  two  separate  journals,  although  they  are  often  bound 
into  one  book.  A  sample  ruling  of  a  Notes  and  Bills 
Eeceivable  Journal  is  shown  in  Figure  26.  The  general 
ledger  postings  are  made  from  the  totals  of  columns  21 
and  22  at  the  end  of  the  month.  The  subsidiary  ledger 


NOTES   AND   BILLS   RECEIVABLE   JOURNAL 
1916 


ACCEJtOR 


IT 


e 


NOTES   AND 


RECEIVABLE   JOURNAL 

1916 


H 


tei 


R^fiffi    "T1" 


I 


TIG.  26. — Posting  Medium  for  Notes  and  Bills  Eeceivable 

(Notes  Receivable  Ledger)  postings  are  made  day  by 
day  to  the  customers7  accounts  shown  in  column  19. 
Columns  7  to  18  inclusive  are  designed  to  show  due  dates 
of  the  various  notes  and  are  not  posted  at  all.  There 
is  no  standard  practice  as  to  the  use  of  these,  columns. 
They  may  show  only  the  day  of  the  month  thus :  a  note 
due  on  August  5  would  be  handled  by  inserting  the  figure 
5  in  column  14.  The  use  of  these  columns  in  this  way 


Development  of  Special  Journals  77 

facilitates  the  preparation  of  schedules  to  show  the 
amount  of  cash  to  be  expected  in  any  future  month. 

The  columns  may  be  used  as  money  columns.  If  so, 
the  amount  of  the  note  is  put  under  the  proper  "  month " 
heading.  For  example,  a  note  receivable  for  $75.00  due 
July  30  will  be  handled  by  putting  $75.00  in  column  13. 
This  procedure  enables  the  treasurer  to  obtain  the  exact 
amount  to  be  expected  from  Notes  Receivable  during  any 
one  month  by  simply  reading  the  columnar  total. 

It  may  be  still  further  elaborated  by  providing  for  both 
the  day  of  the  month  and  the  amount  under  the  name  of 
each  month.  The  illustration  on  the  opposite  page  is 
ruled  in  accordance  with  the  second  plan.  From  the 
columnar  totals  we  see  that  during  the  month  of  May 
$995.25  can  be  expected  to  come  in  to  the  treasury;  in 
July,  $1,579.40;  and  in  September,  $293.30. 

The  Notes  and  Bills  Payable  Journal  is  constructed 
according  to  the  same  general  plan  as  the  form  just 
discussed. 

If  these  two  journals  are  bound  in  the  same  volume, 
care  should  be  exercised  in  order  that  entries  may  not 
be  made  in  the  wrong  journal.  One  of  the  journals  may 
be  printed  and  ruled  in  red  ink  and  the  other  in  black 
ink,  and  different  styles  of  type  may  be  used  to  emphasize 
the  differences  between  the  two. 

SPECIAL  JOURNALS  AND  CONTROL  ACCOUNTS 

When  the  principle  is  thoroughly  grasped  that  journal 
items  referring  to  the  same  account  may  be  set  aside 
unposted  in  a  special  column  until  the  end  of  the  month 
and  then  posted  in  one  lump  sum  and  the  further  principle 
has  been  established  that  special  journals  may  be  split 
off  from  the  General  Journal  to  record  particular  classes 
of  facts,  it  requires  no  imagination  to  see  that  great 


78  Principles  of  Accounting 

elasticity  results.  Special  journals  and  special  columns 
for  those  journals  may  be  designed  to  fit  any  business, 
large  or  small.  These  journals  and  special  columns  have 
for  their  main  purpose  the  collection  and  classification  of 
financial  facts  in  shape  for  posting  to  the  General  Ledger 
control  accounts  by  totals  and  to  subsidiary  ledgers  by 
items.  This  does  not  mean,  of  course,  that  every  general 
ledger  entry  represents  the  total  of  a  column  in  some 
journal.  Certain  kinds  of  items  occur  so  infrequently 
that  it  would  be  unwise  to  provide  special  columns  for 
them.  We  have  seen  that  this  is  provided  for  in  all 
journals  by  means  of  general  columns.  Figures  appear- 
ing in  these  general  columns  are  posted  item  by  item 
to  the  designated  general  ledger  accounts. 

THE  LEDGERS 

Before  considering  the  more  complex  types  of  journals 
it  will  be  well  to  discuss,  in  some  detail,  the  ledgers.  The 
General  Ledger  is  the  book  of  the  business,  being  the 
ultimate  development  of  the  "balance,"  which  was  dis- 
cussed in  Chapter  I.  The  General  Ledger  is  a  bound 
volume  containing  the  accounts  of  the  business.  In  it 
are  recorded,  in  a  more  or  less  summarized  form,  the 
facts  which  are  collected  and  classified  by  the  journals. 
The  General  Ledger  is  the  keystone  of  the  whole  account- 
ing system.  Subordinate  to  it  are  certain  other  ledgers, 
such  as  the  Accounts  Receivable  Ledger  and  the  Accounts 
Payable  Ledger,  each  of  which  gives  the  detail  of  one  of 
the  accounts  in  the  General  Ledger. 

It  is  clear  that  any  clerk  having  access  to  the  General 
Ledger  is  in  a  position  to  know  as  much  about  the  results 
of  the  business  as  the  owner  or  manager.  Some  book- 
keeper must  have  access  to  it,  since  postings  must  be 
made  to  it  and  the  owner  can  hardly  be  expected  to  do 
the  bookkeeping  work  himself.  Most  of  the  general 


Development  of  Special  Journals  79 

ledger  accounts,  however,  are  not  confidential;  only  a 
few  of  them  are  strictly  so. 

The  General  Ledger  may  be  split  into  two  books,  one 
large  enough  to  contain  all  except  private  accounts  and 
the  other  for  all  accounts  which  contain  confidential 
figures.  The  function  of  the  General  Ledger  is  certainly 
not  changed  by  binding  it  in  two  volumes  instead  of  one, 
and  a  very  substantial  advantage  is  gained,  namely,  that 
the  larger  of  the  two  volumes  in  which  most  of  the  clerical 
work  must  be  done  can  be  freely  turned  over  to  the  office 
force  while  the  confidential  ledger  remains  in  the  sole 
possession  of  the  proprietor,  manager,  or  a  trusted 
employee.  These  two  books  are  called  the  General  Ledger 
and  the  Private  Ledger,  although  in  reality  the  General 
Ledger  consists  of  the  two  books  taken  together. 

THE  PKIVATE  LEDGER 

It  is  usual  to  include  in  the  Private  Ledger  only  those 
accounts  which  are  really  significant,  from  which  the 
true  profit  or  loss  is  ascertained  or  the  true  values  of 
fixed  assets  are  determined.  These  accounts  are  not  the 
ones  which  require  much  bookkeeping  work,  but  they 
reflect  the  really  vital  facts  of  the  business.  In  a  trading 
partnership,  the  following  accounts  would  probably  be 
found  in  the  Private  Ledger: 

Land  &  Buildings. 
Furniture  &  Fixtures. 
Investments. 

Inventory  of  Merchandise. 
Capital  Account — Jones. 
Capital  Account — Smith. 
Trading  Account. 
Profit  and  Loss  Account. 

All  other  accounts  would  be  found  in  the  General  Ledger. 


80  Principles  of  Accounting 

Since  these  two  books  are,  in  reality,  merely  separate 
volumes  of  the  same  book,  it  is  clear  that  they  may  be  so 
regarded  when  the  time  comes  to  take  a  trial  balance.  A 
trial  balance  taken  from  either  one  alone  will  be  incom- 
plete. When  they  are  considered  together,  a  complete 
trial  balance  results. 

For  various  practical  reasons  it  is  often  desirable  to 
take  a  trial  balance  of  these  two  books  separately,  and 
to  facilitate  this,  a  "balancing"  account  is  included  in 
each  ledger.  Thus,  the  Private  Ledger  will  contain  a 
General  Ledger  Account,  and  the  General  Ledger  will 
contain  a  Private  Ledger  Account.  When  this  is  done, 
a  complete  trial  balance  may  be  taken  from  either  of  these 
books  alone.  The  method  of  operating  these  "balance" 
accounts  is  simple.  Suppose,  for  example,  that  the  Cash 
Account  is  carried  in  the  General  Ledger  and  that  Jones ' 
Capital  Account  is  carried  in  the  Private  Ledger.  What 
happens  when  Jones  draws  $200.00?  In  the  General 
Ledger  the  following  entry  may  be  made : 

Private  Ledger  Account $200.00 

Cash  $200.00 

and  in  the  Private  Ledger  this  entry  may  be  made : 

Jones '  Capital  Account $200.00 

General  Ledger  Account $200.00 

The  effect,  eliminating  the  balance  account,  is  to  debit 
Jones '  Capital  Account  and  credit  Cash. 

When  an  entry  affects  accounts  in  the  same  ledger, 
whether  it  be  Private  or  General,  nothing  need  be  posted 
to  the  balancing  accounts,  but  when  one  account  in  the 
General  Ledger  and  one  account  in  the  Private  Ledger 
are  affected,  the  balancing  accounts  will  receive  entries. 

For  the  sake  of  illustration,  we  will  assume  the  case 


Development  of  Special  Journals  81 

of  a  company  desiring  to  start  a  Private  Ledger  and 
indicate  the  procedure  necessary. 

The  balance  sheet  of  Cutter  &  Wilson  on  December  31, 
1915,  is  as  follows : 

Liabilities 
Assets  arid 

Capital 
Cash   $     5,000.00 

Accounts  Keceivable  18,000.00 

Notes  Eeceivable  15,000.00 

Merchandise  Inventory    30,000.00 

Land  &  Building 25,000.00 

Furniture  &  Fixtures 8,000.00 

Accounts  Payable   $     6,000.00 

Notes  Payable  15,000.00 

Mortgage  Payable 5,000.00 

Cutter — Capital  Account   * 50,000.00 

Wilson — Capital  Account   25,000.00 


$101,000.00     $101,000.00 

As  of  January  1,  1916,  they  desire  to  open  a  Private 
Ledger,  which  will  be  kept  in  the  possession  of  Mr.  Wil- 
son, and  they  desire  that  the  following  accounts  shall  be 
included  in  that  ledger : 

Merchandise  Inventory    $30,000.00 

Land  &  Building 25,000.00 

Furniture  &  Fixtures 8,000.00 

Mortgage  Payable    5,000.00 

Cutter — Capital  Account   50,000.00 

Wilson — Capital  Account    25,000.00 

(Trading  Account)   

(Profit  and  Loss  Account) 

If  the  General  Ledger  could  be  taken  apart  and  rebound 
in  two  volumes,  one  containing  the  above  accounts  and 
marked  "Private  Ledger "  and  the  other  containing  the 
remaining  accounts  and  marked  "General  Ledger," 
nothing  further  would  be  required  save  to  open  a  balance 
account  in  each,  which  would  be  debited  or  credited  with 


82  Principles  of  Accounting 

amounts  sufficient  to  bring  the  books  to  balance.  Assume, 
however,  that  the  original  General  Ledger  is  a  substan- 
tially bound  book,  as  it  should  be,  and  that  it  is  better 
to  close  out  the  private  accounts  which  appear  in  it, 
leaving  the  other  accounts  as  they  are,  and  to  open  a  new 
book  for  the  Private  Ledger.  To  accomplish  this,  the 
following  entry  should  be  made  in  the  General  Journal 
and  posted  to  the  General  Ledger : 

1916 

Jan.  1     Mortgage  Payable   $  5,000.00 

Cutter— Capital    Account 50,000.00 

Wilson— Capital  Account   25,000.00 

Merchandise  Inventory   $30,000.00 

Land  &  Building   25,000.00 

Furniture  &  Fixtures   8,000.00 

Private  Ledger  Account 17,000.00 

When  this  entry  has  been  made,  a  trial  balance  of  the 
General  Ledger  will  appear  as  follows : 

Cash    $  5,000.00 

Accounts  Eeceivable 18,000.00 

Notes  Eeceivable   15,000.00 

Accounts  Payable $  6,000.00 

Notes  Payable    15,000.00 

Private  Ledger  Account 17,000.00 


$38,000.00     $38,000.00 


To  open  the  Private  Ledger,  a  Private  Journal  is 
appropriate.  In  that  Private  Journal  the  following 
entry  will  be  made: 


1916 

Jan.  1     General   Ledger  Account $17,000.00 

Merchandise  Inventory   30,000.00 

Land  &  Building  25,000.00 

Furniture  &  Fixtures 8,000.00 

Mortgage  Payable   $  5,000.00 

Cutter— Capital    Account 50,000.00 

Wilson — Capital  Account 25,000.00 


Development  of  Special  Journals  83 

When  this  private  journal  entry  has  been  posted  to  the 
Private  Ledger,  a  trial  balance  may  be  taken.  This  trial 
balance  of  the  Private  Ledger  will  appear  as  follows : 

General  Ledger  Account $17,000.00 

Merchandise  Inventory 30,000.00 

Land  &  Building 25,000.00 

Furniture  &  Fixtures  8,000.00 

Mortgage  Payable    $  5,000.00 

Cutter — Capital  Account 50,000.00 

Wilson — Capital  Account 25,000.00 

No  definite  statement  can  be  made  as  to  just  what 
accounts  should  appear  in  the  Private  Ledger.  This  is 
a  matter  for  the  owner  or  manager  of  the  business  to 
decide.  From  the  practical  viewpoint  no  accounts  should 
be  included  in  the  Private  Ledger  that  receive  more  than 
a  few  entries  a  month,  since  it  would  be  unwise  to  burden 
a  high-priced  manager  or  confidential  secretary  with 
routine  bookkeeping  work.  The  Trading  Account,  the 
Inventory  Account,  and  the  Profit  and  Loss  Account 
should  appear  in  the  Private  Ledger,  at  any  rate. 

OTHER  USES  OF  THE  PRIVATE  LEDGER 

In  corporations  it  is  customary  to  have  a  private  salary 
roll  for  the  executives,  so  that  clerks  and  subordinates 
may  not  be  advised  what  salaries  their  superiors'  are 
receiving.  This  may  be  accomplished  in  several  ways. 
One  way  is  to  carry  a  Private  Cash  Account  in  the 
Private  Ledger  and  make  salary  payments  from  this. 
When  the  private  cash  runs  low,  a  replenishing  check 
may  be  issued  from  the  general  cash  and  debited,  in 
the  General  Ledger,  to  the  Private  Ledger  Account. 
In  the  Private  Ledger  the  amount  is  debited  to  Private 
Cash  and  credited  to  General  Ledger  Account. 

The  use  of  a  Private  Ledger  is  highly  desirable  in 


84  Principles  of  Accounting 

a  large  corporation  and  appropriate  in  a  smaller  one. 
There  is  little  or  no  advantage  in  it  for  a  very  small 
business  under  normal  circumstances.  There  is  noth- 
ing mysterious  about  it  if  the  reader  bears  in  mind 
that  it  represents  nothing  more  than  a  few  accounts 
which  have  been  taken  away  from  the  General  Ledger 
and  that,  to  obtain  a  complete  trial  balance,  showing 
all  accounts,  both  books  must  be  used.  The  use  of 
balancing  accounts  between  the  two  books  permits  the 
taking  of  an  independent  trial  balance  of  each. 

Hereafter  when  we  speak  of  the  General  Ledger,  we 
shall  be  referring  not  to  one  specific  bound  volume  but 
to  the  collection  of  general  ledger  accounts,  whether 
part  of  them  are  in  a  private  volume  or  whether  they 
are  all  contained  within  the  same  binding.  It  is  abso- 
lutely immaterial  so  far  as  accounting  theory  is  con- 
cerned whether  the  collection  of  accounts,  which  we 
call  the  General  Ledger,  is  loose  leaf  or  on  cards  or 
firmly  bound  in  one  volume  or  two  volumes.  The  General 
Ledger  exercises  certain  functions,  and  the  interest  is  in 
these  functions  and  not  in  the  physical  form  which  this 
collection  of  accounts  assumes. 

THE  LEDGER  ACCOUNT 

In  the  preceding  chapter  we  traced  the  development 
of  the  account  and  showed  the  standard  form  of  ruling 
for  a  ledger  account.  This  form  is  the  one  most  con- 
stantly used  for  the  General  Ledger.  The  general  ledger 
accounts,  as  we  have  seen,  receive  many  of  their  entries 
in  lump  sum  totals  at  the  end  of  each  month.  The  general 
ledger  accounts  which  are  not  represented  by  special 
columns  in  the  journals,  and  hence  do  not  receive  postings 
by  totals,  are  not  particularly  active.  The  result  is  that 
posting  to  general  ledger  accounts  involves  but  a  small 


Development  of  Special  Journals  85 

percentage  of  the  total  time  of  bookkeepers  and  clerks. 
The  comparatively  small  number  of  general  ledger 
entries  renders  unnecessary  the  introduction  of  special 
forms  of  account  ruling.  This  is  far  from  being  true 
of  the  subsidiary  ledger  accounts  where  the  volume  of 
transactions  may  be  very  large.  For  example,  suppose 


DATE      NUMBER     ITEM       DEBIT 


CREDIT       BALANCE 


FIG.   27. — Accounts   Eeceivable   Ledger   Page 

There  is  little  difference  between  this  and  the  standard  ledger  ruling,  save 
that  the  debit  and  credit  items  are  placed  side  by  side  and  next  to  them  a 
balance  column.  It  is  often  desirable  to  ascertain  a  customer's  balance  quickly. 
If  the  account  is  a  long  one,  it  will  require  some  time  to  determine  the  balance, 
unless  the  balance  is  continuously  brought  forward  in  a  special  column,  as  shown 
in  this  illustration. 

a  company  made  five  hundred  sales  on  credit  during  a 
given  month.  For  these  sales  the  general  ledger  entries 
might  number  only  two — a  debit  to  Accounts  Eeceivable 
and  a  credit  to  Sales  Account  for  the  total  credit  sales 
of  the  month  as  shown  by  the  Sales  Journal.  In  the 
subsidiary  Accounts  Eeceivable  Ledger  there  will  be  five 


86 


Principles  of  Accounting 


hundred  entries  to  be  made.  This  makes  a  total  of  five 
hundred  and  two  postings,  only  two  of  which  are  made 
to  the  General  Ledger. 

In  a  similar  way  five  hundred  receipts  of  cash  from 
customers  recorded  in  the  Cash  Receipts  Journal  would 


DATE 


ITEM 


DEBIT 


CREDIT 


OLD  BALANCE 


FIG.   28. — Accounts  Receivable   Ledger  Page 

This  form  of  account  provides  for  a  current  balance  and  also  an  old  balance. 
This  old  balance  column  is  used  only  when  bookkeeping  machines  are  employed. 
To  the  figure  shown  in  that  column  the  debits  are  added  and  the  credits 
subtracted  to  secure  the  new  balance. 

involve  five  hundred  postings  to  the  subsidiary  Accounts 
Receivable  Ledger  and  only  two  to  the  General  Ledger; 
i.  e.,  debit  Cash  and  credit  Accounts  Receivable  for  the 
total  cash  received  from  customers  as  shown  by  the 
columnar  totals  in  the  Cash  Receipts  Journal. 

It  is  because  of  the  great  amount  of  clerical  work 
involved  in  keeping  the  subsidiary  Accounts  Receivable 
and  Accounts  Payable  Ledgers  that  attention  has  been 


Development  of  Special  Journals 


87 


given  to  the  problems  of  reducing  bookkeeping  cost  and 
increasing  accuracy. 

The  manufacturers  of  adding  and  bookkeeping  ma- 
chines do  not  intend  that  their  products  shall  operate 
on  the  General  Ledger,  where  the  postings  are  compara- 
tively few,  but  on  the  subsidiary  ledgers,  where  the 


DATE  MEMO  CHARGES 


CREDIT       V     BALANCE 


FIG.   29. — Accounts    Receivable   Ledger   Page 

This  is  a  somewhat  more  elaborate  form  of  account  ruling.     The  narrow 
columns  are  used  for  "checking"   purposes. 

postings  are  many,  the  errors  are  frequent,  and  the 
opportunity  for  cost  reduction  is  apparent. 

For  the  same  reasons  the  general  ledger  accounts  are 
in  the  standard  account  form,  but  the  subsidiary  ledger 
accounts  are  especially  ruled  and  often  bear  no  resem- 
blance to  the  standard  form.  Standard  rulings  for  such 
accounts  are  shown  in  Figures  27,  28,  and  29. 


88 


Principles  of  Accounting 
THE  COLUMNAR  LEDGER 


The  columnar  ledger  is  a  useful  device  under  certain 
restricted  circumstances  where  the  number  of  customers 
is  large  and  the  monthly  transactions  are  few,  such  as 
the  electric  light  business.  The  ledger  page  may  contain 


PURCHASE    JOURNAL 


MERCHANDISE  PURCHASES  ACCOUNTS 


ACCOUNTS 

PAYABLE 

O. 


370 


/ 


2.2S 


/t? 


119 


FIG.  30. — Columnarized  Purchase  Journal 

as  many  as  fifteen  or  twenty  accounts.  Each  account 
consists  of  one  or  more  lines,  depending  upon  cir- 
cumstances. Banks  formerly  employed  the  columnar 
ledger,  but  have  just  about  abandoned  it  because  of  the 
introduction  of  moderi}  mechanical  bookkeeping  methods 
which  give  better  results.  Where  used  by  banks,  the 
columnar  ledger  is  often  called  the  "Boston  Ledger.'7 


Development  of  Special  Journals  89 

Owing  to  the  fact  that  this  form  is  falling  into  disuse,  we 
will  neither  illustrate  or  describe  it. 

THE  COLUMNAR  PURCHASE  JOURNAL 

The  Purchase  Journal,  which  we  have  already  dis- 
cussed, has  two  functions :  (1)  Its  total  is  posted  to  the 
debit  of  Merchandise  Purchases  and  credited  to  Accounts 
Payable  Account  in  the  General  Ledger.  (2)  Its  detail 
is  posted,  item  by  item,  to  the  various  personal  accounts 
in  the  Accounts  Payable  Ledger.  If  it  seems  desirable 
to  show  greater  detail  on  the  General  Ledger,  the  single 
debit  to  Merchandise  Purchases  may  be  split  into  several 
debits  to  several  classes  of  Merchandise  Purchases 
Accounts. 

Suppose,  for  example,  that  a  business  has  five  depart- 
ments and  carries  in  its  General  Ledger  five  departmental 
Merchandise  Purchase  Accounts.  In  order  to  charge 
purchases  direct  to  the  proper  accounts,  it  will  require 
a  columnar  Purchase  Journal.  Such  a  Purchase  Journal 
might  be  ruled  as  shown  in  Figure  30. 

Putting  the  same  items  in  conventional  journal  entry 
form  we  have  the  following: 

Merchandise  Purchases  Account,  Dept.  A $8,521.00 

««  "  <<  «       B 998.00 

"  "  "  "       C 4,006.00 

"  "  "  '*       D 1,250.00 

"  "  "          "       E 3,081.00 

Accounts  Payable   $17,856.00 

In  addition  to  the  above  general  ledger  entries,  there 
will  be  the  usual  credits  to  the  individual  creditors' 
accounts  in  the  subsidiary  Accounts  Payable  Ledger. 

THE  VOUCHER  REGISTER 

A  form  of  journal  like  this  may  be  greatly  expanded, 
of  course,  by  the  insertion  of  extra  columns.  It  may 


90  Principles  of  Accounting 

also  be  changed  in  character  somewhat,  since  it  forms 
an  ideal  medium  for  the  distribution  of  charges  not  only 
in  connection  with  purchases,  but  of  other  items  which 
are  to  be  paid  out  in  money.  By  including  debit  columns 
for  expenses  such  as  wages,  salaries,  selling  expense, 
general  overhead  expense,  etc.,  and  columns  for  the 
various  charges  to  capital  accounts,  such  as  Machinery, 
Tools,  etc.,  we  change  the  character  of  the  Purchase 
Journal,  forming  another  journal  commonly  called  the 
"Voucher  Register. "  This  name  arises  because  of  the 
common  use  of  vouchers  in  modern  business. 

According  to  Webster's  New  International  Dictionary, 
a  voucher  is  ' i  a  book,  paper,  or  other  thing  which  serves 
to  vouch  (affirm)  the  truth  of  accounts. " 

Where  the  voucher  system  is  in  use,  every  invoice  or 
bill  that  is  received  must  be  vouchered  before  the  disburs- 
ing office  may  pay  it.  By  this  we  mean  that  it  must  be 
O.  K.  'd  or  approved  by  two  or  more  responsible  persons 
as  to: 

1.  Authentication  of  purchase 

(approved  by  purchasing  agent). 

2.  Quantities,  prices,  grades,  sizes,  quality,  etc. 

(approved  by  purchasing  agent). 

3.  Actual  receipt  (approved  by  receiving  clerk). 

(a)  Quantity. 

(b)  Sizes. 

(c)  Class. 

(d)  Kind. 

(e)  Quality. 

(f)  Condition. 

4.  Mathematical  accuracy  of  extensions 

(approved  by  checking  clerk). 


Development  of  Special  Journals  91 

5.  Terms  of  payment 

(approved  by  purchasing  agent). 

6.  Distribution 

(approved  by  bookkeeper  or  auditor). 

The  usual  method  is  to  have  a  standard  form  of 
voucher,  which  is  technically  called  a  "voucher  jacket." 
(See  Figures  31  and  32.)  The  data  shown  on  the  invoice 
or  bill  is  entered  on  the  voucher  jacket,  and  the  invoice 
itself  is  pinned  to  the  voucher  jacket  and  temporarily 
filed,  alphabetically,  in  the  accounting  department. 
From  time  to  time  other  invoices  from  the  same  creditor 
may  be  received.  If  so,  they  are  entered  on  and  pinned 
to  the  same  voucher  jacket.  At  the  end  of  the  month  or 
the  week  the  voucher 2  with  all  invoices  attached  is  sent 
to  the  proper  employees  and  department  heads  for  their 
O.  K.,  after  which  it  comes  back  to  the  accounting  depart- 
ment, where  it  is  entered  in  the  Voucher  Eegister.  It  is 
then  refiled  until  a  check  is  issued  in  payment.  This 
check  may  be  accompanied  by  the  voucher  jacket  (the 
invoices  being  detached),  which  must  be  signed  and 
returned  by  the  payee  as  a  receipt.  Paid  vouchers  are 
permanently  filed  in  the  accounting  department  numer- 
ically by  voucher  numbers. 

The  technique  of  handling  the  Voucher  Register  is  a 
matter  of  bookkeeping  and  has  no  place  in  this  volume. 
It  may  be  a  matter  of  some  interest,  however,  to  illustrate 
some  typical  transactions  and  the  manner  of  booking 
them. 

The    following    transactions    are    illustrated    in    the 

2  When  a  discount  is  obtainable,  it  is  customary  to  voucher  the  invoice 
and  make  payment  without  actually  waiting  until  the  end  of  the  month  or 
week. 


92 


Principles  of  Accounting 


CHICAGO.  li_i 

THE   BLANK  COMPANY 

TO 


EMS  SUB-TOTALS 


CORRECT   AS   TO:    EXTENSIOf 

TCRMS QU  ANTPTI E 

AUDITED  AND  O.  K.'O  BY; 


APPROVED: 


VOUCHER  NO.. 
.BY 


FiQ.  31. — Front  of  Voucher  Jacket 
For  reverse,  see  Fig.  32. 


VOUCHER  No.____  I 

THE  BLANK  COMPANY 

CHICAGO.  ll_l_ 

; 

£ 

|! 

1 

j  • 

ii 

1  5 

I 

p 

5 
n 

KV 

N 

<f 
I 

CO 
V) 

» 

1 

I 

1  1  PRODUCTIVE  LABOR 

h 
< 

2 

|  |  FACTORY  EXPENSE 

UI 
(0 

I 

5 
? 

s 

|  |  ADMIN.  EXPENSE 

Fio.  32. — Reverse  of  Voucher  Jacket  Shown  in  Fig.  31 


Development  of  Special  Journals 


93 


Voucher    Eegister    and    in    the    Cash    Disbursements 
Journal : 

March  2,  1916  Invoice  for  raw  material,  $1,122.19, 
received  from  Simmond's  Steel  Co., 
Chicago,  111. 

March  4  Invoice  for  $10,000.00,  covering  ma- 

chinery received  from  the  Automatic 
Machinery  Co.,  of  Cincinnati,  Ohio. 

March  6  Invoice  for  small  tools,  $218.92,  from 

the  Tungsten  Tool  Co.,  Tupelo,  Miss. 

March  15  Payroll  for  half -month  totals,  $2,392.38, 

chargeable  as  follows:  Productive 
Labor,  $1,265.98;  Factory  Expense 
(non-productive  labor) ,  $298.18 ; 
Administrative  Expense  (office  pay- 
roll), $301.00;  Selling  Expense 
(salesmen's  salaries),  $527.22. 

March  19  Invoice  for  raw  material,  $763.00,  from 

Simmond's  Steel  Co. 

March  22  Bill  for  month's  rent  of  factory  and 

office,  amounting  to  $400.00,  from 
Acme  Real  Estate  Co.  This  is 
chargeable  as  follows :  Factory  Ex- 
pense, $300.00;  Administrative  Ex- 
pense, $100.00. 

March  24  Bill  for  repairs  to  office  adding  machine 

received  from  Eapid  Adder  Co., 
Detroit,  Mich.,  amounting  to  $10.00. 

March  27  Invoice  for  raw  material,  $381.00,  sub- 

ject to  1%  discount  if  paid  within 
ten  days,  received  from  the  Cleve- 
land Eubber  Co. 


94  Principles  of  Accounting 

March  29  Invoice  for  raw  material,  $100.277, 

subject  to  3%  discount  within  ten 
days,  received  from  John  Stewart 
Co.,  Baltimore,  Md. 

March  31  Payroll  for  half -month  totals,  $2,477.15, 

chargeable  as  follows:  Productive 
Labor,  $1,325.71 ;  Non-productive 
Labor,  $301.19;  Office  Payroll,  $327.- 
06;  Salesmen's  Salaries,  $523.19. 

When  payments  are  made,  they  are  recorded  in  the 
Cash  Disbursements  Journal  to  the  credit  of  Cash  (and 
Purchase  Discounts,  if  taken)  and  to  the  debit  of  Voucher 
Payable,  thus: 


CASH    DISBURSEMENTS 


Hf 


FIG.  33. — Cash  Disbursements 

When  all  postings  have  been  made,  it  will  be  seen  that 
the  balance  of  the  Vouchers  Payable  Account  represents 
the  total  amount  owing  not  only  for  purchases  of 
merchandise,  but  for  unpaid  wages  and  salaries  and 
purchases  of  all  sorts  of  supplies  and  tools,  rent,  interest, 
etc.,  whereas  the  old  Purchase  Journal  was  only  used 
for  purchases  of  merchandise. 


Development  of  Special  Journals 


95 


96 


Principles  of  Accounting 


Where  the  Voucher  Eegister  is  used,  it  is  customary 
to  do  away  with  the  formal  Accounts  Payable  Ledger. 
When  checks  are  issued  in  payment  of  a  voucher,  a  nota- 
tion is  made  on  the  Voucher  Register  itself  in  the  space 
provided  for  that  purpose.  All  unpaid  vouchers  are 
alphabetically  kept  in  a  separate  file,  so  that  they  may 
easily  be  located,  if  necessary.  The  Vouchers  Payable 
Account  in  the  General  Ledger  is  the  controlling  account 
over  the  unpaid  vouchers  in  this  file.  When  a  voucher 
is  paid,  it  is  filed,  according  to  the  voucher  number,  in 
another  cabinet.  An  alphabetical  card  index  of  these 
paid  vouchers  is  kept  so  that  it  is  possible  to  locate  all 
vouchers  to  any  one  firm  by  obtaining  the  voucher  num- 
bers from  the  card  index  and  thus  locating  the  vouchers 
themselves.  Such  an  index  card  might  appropriately 
appear  as  follows: 


Cleveland  Rubber  Co«,  Cleveland,  Ohio 

1912 

12 
TT 

1915 

3 

K 

5   8  12 
"55  75  1? 

1914 

7 

75 

9 
85 

1915 

2 

w 

4 
106 

This  card  shows  vouchers  for  the  Cleveland  Eubber 
Company,  as  follows : 


Development  of  Special  Journals  97 


Voucher  No.  11  drawn  in  December  1912 

«         «      24 

March         1913 

"         "      32 
"          "      45 
"          "      58 

May            1913 
August        1913 
December   1913 

«         '<      72 
tt         t(      83 

"         "      98 
"         "    106 

July            1914 
September  1914 
February    1915 
April           1915 

If,  at  any  time,  it  is  desired  to  make  a  complete  survey 
of  past  dealings  with  the  Cleveland  Rubber  Company,  the 
various  voucher  numbers  may  be  ascertained  from  this 
card  and  the  vouchers  themselves  drawn  from  the 
numerical  file  of  "paid  vouchers. " 

From  the  foregoing  it  can  be  seen  that  there  is  no  need 
of  an  actual  bound  Accounts  Payable  Ledger.  The 
vouchers  themselves  form  such  a  ledger  in  loose-leaf 
form. 

THE  STATUS  OF  THE  JOURNAL 

In  the  early  portion  of  this  chapter,  we  based  tke 
entire  discussion  upon  the  Journal.  In  the  beginning 
all  general  ledger  entries  were  passed  through  the  Jour- 
nal, but  for  certain  reasons  heretofore  discussed  it  has 
been  found  desirable  to  abstract,  segregate,  or  split  off 
certain  journal  functions,  using  separate  books  for  han- 
dling each  class  of  items.  The  original  journal,  by  this 
process  of  abstractions,  has  been  robbed  of  practically 
all  the  entries  which  formerly  passed  through  it  on  their 
way  to  the  Ledger.  Only  a  few  transactions  are  of  such 
a  nature  that  they  must  be  handled  in  the  Journal;  the 
great  majority  flow  naturally  through  one  of  the  following 
special  journals : 

Cash  Receipts  Journal. 
Cash  Disbursements  Journal. 


98 


Principles  of  Accounting 


Sales  Journal. 

Notes  and  Bills  Eeceivable  Journal. 
Notes  and  Bills  Payable  Journal. 
Voucher  Eegister. 

The  items  which  must  be  journalized,  although  few  in 
number,  are  very  important.    In  the  main  they  consist 


THE    BLANK   COMPANY 

D  AND  C                                ACCOUNTING  DEPARTMENT 
MKMa                                                              CHICAGO.  ILL* 

...  10 

H 

• 

DEBIT 

'   CREDIT 

HEMARKS 

CORRECTi                                                 APPROVED  FOR  ENTRY, 

FIG.  35. — Front  of  Journal  Voucher 
For  reverse,  see  Fig.  36. 


of  opening  and  closing  entries  and  adjustment  and  correc- 
tion entries.  Such  important  entries  must  be  accom- 
panied by  full  and  complete  explanations  written  as.  an 
integral  portion  of  the  journal  entry  itself.  As  a 
substitute  for  these  cumbersome,  formal,  and  long-winded 
explanations,  a  journal  voucher  is  now  largely  used.  (See 
Figures  35,  36,  and  37.)  To  the  journal  voucher  are 


Development  of  Special  Journals 


99 


fastened  supporting  schedules,  papers,  letters,  and 
memoranda,  and  from  this  journal  voucher  the  journal 
entry  is  made.  The  journal  voucher  is,  of  course, 
numbered,  and  the  journal  entry  shows  that  number. 


DAT 

f  OF  FNTFY..         ,  ...  '»! 

JOURNAL  VOUCHER  No  

Name. 

Address 

DEBIT  ACCOUNTS 

AMOUNTS 

CREDIT  ACCOUNTS 

AMOUNTS 

Accounts  Receivable 

Accounts  Receivable 

Accounts  Payable 

Accounts  Payable 

GRAND  TOTAL 

GRAND  TOTAL 

Folio 

Accounts  ?£  Items 

Folio 

Accounts  ?.;<;  Items 

TOTALJ 

TOTAL 

FIG.  3$. — Reverse  of  Journal  Voucher  Shown  in  Fig.  35 

The  journal  entry  may  be  brief,  since  it  is  supported 
by  the  complete  journal  voucher,  containing  all  the 
information,  which  may  be  drawn  from  the  file  when 
needed. 


100 


Principles  of  Accounting 


With  the  foregoing  arrangement  it  is  clear  that  files 
must  be  provided  for  two  kinds  of  vouchers:  (a) 
expenditure  vouchers  which  support  voucher  register 
entries  and  (b)  journal  vouchers  which  support  entries 
in  the  Journal.  Journal  vouchers  must  be  filed  and 
safeguarded  with  as  much  care  as  vouchers  for  expendi- 
tures. There  is  nothing  illogical,  therefore,  in  filing 
both  in  the  same  filing  cabinet.  The  numbering  system 


o 

MILWAUKEE  WATER  WORKS 
JOURNAL  VOUCHER 

—  —  —  —  . 

r° 

APPROVED                                                                                                           CORRECT 

CHIC*  ACCOUNTANT                                                                                                                              Boo««««M» 

FIG.  37. — Journal  Voucher  Which  Is  to  Be  Bound  and  Used  as  a  Posting 

Medium 
Supporting  papers  are  filed  in  ordinary  letter  files. 

must  be  handled  so  that  no  duplicate  numbers  will 
appear. 

If  the  vouchers  can  be  handled  in  this  way,  it  is  natural 
to  ask  why  the  Journal  and  the  Voucher  Register  cannot 
be  similarly  combined.  Progressive  accountants  have 
done  this,  and  the  results  are  satisfactory.  It  is  required 
only  to  add  more  columns  to  the  Voucher  Register.  These 
columns  are  used  for  journal  entries  and  do  not  interfere 
in  the  least  with  the  functions  of  the  Voucher  Register. 

If  there  were  many  journal  entries,  such  a  plan  would 


Development  of  Special  Journals  101 

prove  cumbersome;  when  only  a  few  appear  each  month, 
it  is  highly  desirable  because  of: 

1.  Uniform  handling  of  all  vouchers. 

2.  Eliminating  one  book  (the  Journal). 

Figure  38  shows  a  Journal  containing  certain  entries. 
Figure  39  shows  the  Journal  combined  with  the  Voucher 
Register  in  the  manner  suggested. 

This  last  step  eliminates  the  Journal  entirely  as  a 
separate  book.  In  fundamental  theory  the  Journal  is 
the  book  that  receives  all  entries  which  are  to  be  posted 
to  the  General  Ledger.  In  practice  the  Journal  is  not 
a  book  at  all.  It  is  nothing  more  than  a  function  which 
is  exercised  by  a  collection  of  books  which  we  have  called 
'  '  special  journals.  '  '  As  long  as  their  common  '  '  journal  '  ' 
function  is  understood,  it  makes  no  difference  what  they 
are  called.  As  a  matter  of  fact,  most  accountants  refer 
to  the  Cash  Book  instead  of  the  Cash  Journal;  to  the 
Sales  Book  rather  than  the  Sales  Journal,  etc. 

Because  of  the  fundamental  importance  of  the  idea,  it 
will  bear  repetition  to  say  that  the  Journal  is  a  collection 
of  all  the  books  which  have  the  common  function  of 
serving  as  mediums  for  posting  to  the  General  Ledger. 

C  Cash  Disbursements  Book. 
Cash  Book 


Sales  Book. 

Notes  and  Bills  Eeceivable  Journal 
The  Journal  embraces  -|  Notes  and  BiUfl  Payable  J(mrnal 

Voucher  Register. 
General  Journal. 
Etc. 

POSTING  TECHNIQUE 

Webster's  New  International  Dictionary  defines  the 
word  "post"  as  follows:     "To  transfer  or  carry  (an 


102 


Principles  of  Accounting 


DATE 


EXPLANATION 


ACCOUNT 


DEBIT 


r/ 


Y  '^. 


fO.  P. 


V 


<Z7~Q 


<4/     /oS.j    -tt&r**-*^* 


<rf~^t*i*-o  £is+++*++*s*$- 


n 


FIG.  38. — Journal  Page 
Compare  with  Fig.  39. 


Development  of  Special  Journals 


103 


•I! 


ill 


•§ 


104  Principles  of  Accounting 

entry  or  item)  from  an  auxiliary  book  to  a  more  formal 
book,  as  from  the  Journal  to  the  Ledger.'' 

This  is  correct  so  far  as  it  goes,  but  proper  posting 
implies  at  least  two  things  not  mentioned  in  this  defini- 
tion. When  a  ledger  posting  is  made,  it  is  not  sufficient 
merely  to  post  the  date  and  amount.  The  nature  of  the 
"contra"  item  should  also  be  indicated.  Thus,  if  Cash 
is  credited  and  Notes  Payable  debited,  the  word  "cash" 
should  appear  in  the  explanation  column  of  the  Notes 
Payable  Account.  This  procedure  is  even  more  important 
on  the  subsidiary  ledger  accounts  than  on  the  general 
ledger  accounts.  The  second  important  point  is  in  con- 
nection with  the  use  of  the  ' l  folio ' '  columns  which  appear 
in  all  the  books,  both  journals  and  ledgers.  They  are 
primarily  intended  for  "check"  marks  to  indicate  the 
items  that  have  been  posted.  As  soon  as  a  posting  is 
accomplished,  a  "check"  is  made  in  the  Journal,  opposite 
the  item  and  in  the  "folio"  column.  This  removes  all 
danger  that  the  item  will  be  posted  twice  in  error. 
Instead  of  using  the  simple  "check  mark"  it  is  now 
customary  to  insert  the  number  of  the  ledger  page  to 
which  the  item  was  posted  and  in  the  ledger  folio  column 
the  page  of  the  Journal  from  which  the  item  is  inserted. 
This  "cross-indexing"  makes  it  very  easy  to  trace  items 
through  the  books,  and  if  these  figures  are  not  inserted 
in  the  "folio"  columns  until  after  the  item  has  been 
posted,  they  also  serve  as  a  check  against  double  post- 
ing it. 

CONCLUSION 

In  order  to  develop  the  fundamental  theory  of  the 
Ledger,  the  subsidiary  ledgers,  and  the  journals  properly, 
it  is  essential  to  avoid  the  complex.  If  this  is  not  done, 


Development  of  Special  Journals  105 

the  proper  perspective  will  be  lost,  with  resulting  failure 
to  create  a  vivid  picture  in  the  reader's  mind. 

In  order  to  develop  the  really  vital  ideas,  it  has  seemed 
wise  not  to  obscure  the  presentation  by  elaborately  ruled 
forms  or  many  special  journals.  One  who  understands 
the  essentials  of  a  journal  or  the  purpose  of  a  form  can 
design  special  journals  and  forms  to  fit  particular  situa- 
tions and  can  analyze  those  he  finds  in  any  accounting 
department.  Every  book  or  sheet  from  which  postings 
are  made  to  the  General  Ledger  is  a  journal,  and  any 
book  which  does  not  serve  as  a  posting  medium,  but 
rather  gives  complete  details  of  a  general  ledger  account, 
is  a  subsidiary  ledger.  Using  the  General  Ledger  as  a 
basing  point,  it  is  easy  to  determine  just  what  relation 
any  other  book  bears  to  it. 

TEST  QUESTIONS 

1.  What  two  functions  are  served  by  special  journal  columns? 

2.  Define  the  Private  Ledger  and  explain  its  relation  to  the 
accounting  system  as  a  whole. 

3.  (a)  What  is  the  function  of  the  Voucher  Register? 

(b)  How  may  the  formal  Accounts  Payable  Ledger  be 
eliminated  ? 

4.  What  are  the  essentials  of  posting  technique? 


CHAPTER  IV 

THE  BALANCE  SHEET 

The  trial  balance  has  been  mentioned  as  a  device  for 
determining  whether  the  General  Ledger  is  in  balance. 
It  is  the  means  of  testing  for  incompleteness  of  entry. 
It  does  not  pretend  to  indicate  whether  all  postings  have 
been  correctly  made,  but  merely  whether  the  law  of 
double  entry  has  been  observed. 

THE  TKIAL  BALANCE 

A  trial  balance  results  from  listing  the  names  of  all 
general  ledger  accounts,  carrying  out  opposite  the  name 
of  each  account,  first  the  total  of  the  debit,  and  then  the 
total  of  the  credit  items.  If  desired,  only  the  balance 
of  each  account  may  be  used,  debit  balances  being  inserted 
in  one  column  and  credit  balances  in  an  adjacent  column 
to  the  right.  The  aggregate  of  totals  of  the  left,  or  debit 
column,  should  be  exactly  equal  to  the  aggregate  of  totals 
of  the  credit  column.  If  this  balance  is  "  struck, "  it  may 
be  assumed  that  the  General  Ledger  from  which  the 
figures  have  been  taken  is  also  in  balance. 

A  trial  balance  taken  from  the  General  Ledger  of 
Arthur  B.  Clark  on  December  31, 1915,  is  as  follows : 

TRIAL  BALANCE — ARTHUR  B.  CLARK 
December  31,  1915 

Debits  Credits 

Cash  $  3,263.78 

Accounts  Eeeeivable 350.00 

Notes  Eeeeivable 1,050.00 

Furniture  &  Fixtures  450.00 

106 


Balance  Sheet  107 

Debits          Credits 

Accounts  Payable  $     306.47 

Arthur  B.  Clark 9,000.00 

Sales 3,012.49 

Purchase  Discounts    29.2] 

Merchandise  Purchases    6,998.28 

Expense   223.11 

Sales  Discounts   12.00 

Interest   .  1.00 


$12,348.17     $12,348.17 

Examining  this  trial  balance  critically  we  perceive  that 
it  means  little  without  additional  data.  It  is  apparent 
that  the  business  has  on  hand  $3,263.78  in  cash.  Pre- 
sumably this  figure  has  been  verified  by  an  actual  count 
or  inventory  of  the  cash  itself.  Can  the  same  thing  be 
said  of  the  next  item,  Accounts  Eeceivable  $350.00? 
Probably  not,  since  it  represents  claims  against  debtors, 
some  of  whom  may  conceivably  fail  to  pay  in  full. 

Furniture  and  Fixtures  Account  represents  a  tangible 
asset.  This  account  was  charged  with  the  cost  price  of 
the  furniture  and  fixtures  at  the  time  of  purchase. 
Probably  this  account  does  not  represent  the  exact  truth 
at  the  time  of  this  trial  balance,  since  the  value  of  such 
assets  continually  diminishes  due  to  the  ravages  of  time 
and  ordinary  wear  and  tear. 

Accounts  Payable  may  be  assumed  correct  since  an 
incentive  to  overstate  it  is  lacking  and  an  understatement 
of  the  total  may  be  developed  by  examination,  or  audit 
of  the  books. 

The  items  of  Sales,  Purchases,  Discounts,  Expenses, 
and  Interest  are  nominal  or  proprietorship  accounts, 
which,  after  the  inventory  has  been  applied,  must  be 
combined  or  merged  in  order  to  obtain  the  net  figure 
representing  an  increase  or  decrease  in  the  proprietor's 


108  Principles  of  Accounting 

interest.  This  balance  must  then  be  credited  or  debited 
to  the  A.  B.  Clark  (proprietor)  Account.  The  final 
balance  of  the  proprietor's  account  will  represent  the 
total  of  his  interest  in  the  business,  or  to  phrase  it  dif- 
ferently, the  amount  which  the  business  appears  to  owe 
the  proprietor. 

Merchandise  Purchases  $6,998.28  represents  the  cost 
of  the  total  material  purchased  during  the  accounting 
period.  This  figure,  less  the  inventory  of  merchandise 
remaining  on  hand,  at  cost,  must  be  equal  to  the  cost 
of  the  goods  which  have  been  sold. 

The  inventory  on  December  31,  1915,  equals  $4,500.00 

Purchases    $6,998.28 

Less — Inventory    4,500.00 


Cost  of  Merchandise  Sold $2,498.28 

In  order  to  obtain  the  net  amount  due  to  or  from  the 
proprietor,  a  calculation  may  be  made  as  follows : 

EXPENSES  OB  LOSSES  INCOME  OR  GAINS 

Purchases    $6,998.28  Sales $3,012.49 

Inventory    4,500.00  $2,498.28      Purchase    Discounts 29.21 


Expense      223.11  $3,041.70 

Interest   1.00 

Sales   Discounts...  12.00 


$2,734.39  2,734.39 


Amount  to  be  credited  to  A.  B.  Clark's  Account $    307.31 

Is  this  figure  correct? 

The  answer  must  be  ' '  No, ' '  since  it  has  been  admitted 
that  two  of  the  assets  are  really  worth  less  than  the 
balance  shown  by  their  ledger  accounts. 

The  Furniture  and  Fixtures  Account  shows  a  balance 


Balance  Sheet  109 

of  $450.00.  This  represents,  we  will  suppose,  the  cost  of 
these  assets  at  the  time  of  purchase.  They  are  unques- 
tionably worth  less  at  a  later  date.  If  they  are  appraised 
at  $400.00  on  December  31,  1915,  but  are  still  carried  in 
the  account  at  original  cost,  $450.00,  it  is  evident  that 
this  account  does  not  tell  the  truth.  A  loss  of  $50.00  has 
been  suffered  and  should  be  debited  to  the  Proprietor's 
Account  (or,  better  still,  to  one  of  his  classified  subsidiary 
accounts). 

It  has  also  been  agreed  that  Accounts  Receivable  may 
not  be  worth  $350.00.  Suppose  that  a  critical  examina- 
tion of  the  several  customers '  accounts  develops  that  one 
of  the  customers,  H.  I.  Joy,  who  owes  the  business  $10.00, 
has  become  insolvent.  The  balance  of  the  Accounts 
Receivable  Account  $350.00  does  not  reflect  the  truth. 
The  amount  should  be  $340.00,  and  the  $10.00  loss  is 
properly  a  debit  to  the  proprietor. 

The  calculation  previously  made  for  determination  of 
the  proper  amounts  to  be  charged  or  credited  to  the 
proprietor  is  not  complete.  The  following  figures  will 
result  in  the  correct  amount  if  good  judgment  has  been 
exercised  in  appraising  the  two  assets,  Accounts  Receiv- 
able and  Furniture  and  Fixtures. 

EXPENSES  OR  COSTS  INCOME  OR  GAINS 

Purchases   $6,998.28  Sales    $3,012.49 

Inventory    4,500.00  $2,498.28       Purchase  Discounts 29.21 


Expense  i    '283.11  $3,041.70 

Interest 1.00 

Sales  Discount  .  12.00 


$2,794.39  2,794.39 

Amount  to  be  credited  to  A.  B.  Clark 's  Account $    247.31 

i  The  $10.00  loss  on  Accounts  Receivable  and  the  $50.00  loss  on  Furniture 
and  Fixtures  have  been  included  in  Expense. 


110  Principles  of  Accounting 

The  above  calculation  is  appropriate  to  reach  a  net 
figure  representing  the  profit  which  is  creditable  to  A. 
B.  Clark 's  Account.  In  the  General  Ledger  the  balances 
of  the  various  accounts  would  be  transferred,  in  accord- 
ance with  the  rules  of  double  entry,  to  the  Proprietor's 
Account.  Since  no  posting  should  be  made  to  a  general 
ledger  account,  save  through  a  journal,  the  first  task  is 
to  frame  up  proper  entries  which,  when  posted,  will  result 
in  a  final  credit  of  $247.31  to  A.  B.  Clark's  Account. 
Such  entries  are  technically  known  as  "closing  entries. " 

PKOFIT  AND  Loss  ACCOUNT 

It  is  customary  to  open  a  temporary  account  called  the 
"Profit  and  Loss  Account, "  to  which  are  posted  the 
sundry  debit  and  credit  balances  of  the  nominal  or 
proprietorship  accounts.  The  final  balance  of  this  Profit 
and  Loss  Account  will  then  represent  the  net  amount  to 
be  debited  or  credited  to  the  main  Proprietor 's  Account. 

ADJUSTMENT  JOURNAL  ENTRIES — A.  B.  CLARK 

1915 

Dec.  31     Expense    $50.00 

Furniture  &  Fixtures $50.00 

To  provide  for  the  shrinkage  in  value  of  the  asset, 
Furniture  &  Fixtures,  by  means  of  a  transfer  of 
the  amount  representing  loss,  to  the  nominal, 
or  proprietorship,  account,  Expense 

Dec.  31     Expense    $10.00 

Accounts  Receivable  $10.00 

(Also  credit  H.  I.  Joy's  account,  in  the  Accounts 
Receivable  Ledger,  $10.00.) 

The  above  entry  provides  for  the  shrinkage  in  the 
value  of  Accounts  Eeceivable  by  means  of  a 
transfer  of  the  amount  representing  loss  to  the 
nominal  account,  Expense 

After  these  two  journal  entries  have  been  posted,  a 
trial  balance  of  the  General  Ledger  will  appear  as  follows : 


Balcmce  Sheet  111 

TRIAL  BALANCE,  DECEMBER  31,  1915 

Debits  Credits 

Cash   $  3,263.78 

Accounts  Receivable  340.00 

Notes  Receivable 1,050.00 

Furniture  &  Fixtures 400.00 

Accounts  Payable   $      306.47 

Arthur  B.  Clark 9,000.00 

Sales 3,012.49 

Purchase  Discounts 29.21 

Merchandise    Purchases    6,998.28 

Expense   283.11 

Sales  Discounts   ...^ . ..._ - ^~^          12-00 

Interest   1.00 


$12,348.17         $12,348.17 

The  following  journal  entries  will  then  be  made  for 
the  purpose  of  transferring  the  balances  of  the  nominal 
accounts  to  the  Profit  and  Loss  Account  which  will  be 
opened  in  the  General  Ledger. 

1915 

Dec.  31     Sales    Account (a)  $3,012,49 

Profit  and  Loss  Account (a)  $3,012.49 

Dec.  31     Purchase  Discounts  Account (b)          29.21 

Profit  and  Loss  Account (b)  29.21 

Dec.  31     Merchandise  Inventory  Account (c)     4,500.00 

Profit  and  Loss  Account (c)     2,498.28 

Merchandise  Purchases  Account (c)  .     6,998.28 

Dec.  31     Profit  and  Loss  Account (d)        283.11 

Expense  Account (d)  283.11 

Dec.  31     Profit  and  Loss  Account (e)          12.00 

Sales  Discounts  Account (e)  12.00 

Dec.  31     Profit  and  Loss  Account (f)  1.00 

Interest   Account (f)  LOO 

The  general  ledger  account  called  "Profit  and  Loss" 


112 


Principles  of  Accounting 


will  appear  as  follows  after  the  postings  have  been  made 
from  the  Journal: 


PROFIT  AND  Loss  ACCOUNT 


1915 

Dec.  31 
31 
31 
31 


Cost  of  Sales,  (c)  $2,498.28 

Expenses  . . .  (d)  283.11 

Sales  Dscts..(e)  12.00 

Interest   (f )  1.00 


1915 

Dec.  31     Sales    (a)   $3,012.49 

31     Purchase 

Dscts (b)          29.21 


The  total  of  the  debits  in  this  account  equals  $2,794.39, 
and  the  total  of  the  credits  equals  $3,041.70,  or  a  differ- 
ence of  $247.31,  which  equals  the  net  profit.  If  the  debit 
total  had  been  larger  than  the  credit  total,  it  would  indi- 
cate that  a  loss  had  been  suffered. 

A  trial  balance  of  the  General  Ledger  after  posting 
will  appear  as  follows: 

Debit  Credit 

Cash    $3,263.78 

Accounts    Eeceivable , 340.00 

Notes    Keceivable 1,050.00 

Merchandise    Inventory 4,500.00 

Furniture   &   Fixtures 400.00 

Accounts  Payable $    306.47 

Arthur  B.  Clark 9,000.00 

Profit  and  Loss  Account 247.31 

$9,553.78     $9,553.78 

The  final  closing  journal  entry  transfers  the  balance 
of  the  Profit  and  Loss  Discount  to  the  Proprietor's 
Account. 

1915 

Dec.  31     Profit    and    Loss    Account $247.31 

A.  B.  Clark — Capital  Account $247.31 

This  entry  having  been  posted,  the  following  trial 
balance  may  be  taken  from  the  General  Ledger. 


Balance  Sheet  113 

Debit          Credit 

Cash    $3,263.78 

Accounts    Eeceivable 340.00 

Notes   Eeceivable 1,050.00 

Merchandise    Inventory 4,500.00 

Furniture   &   Fixtures 400.00 

Accounts    Payable $    306.47 

A.  B.  Clark — Capital  Account 9,247.31 

$9,553.78     $9,553.78 

The  above  exhibit  is  technically  known  as  "balance 
sheet."  Strictly,  a  balance  sheet  is  a  trial  balance  of 
the  General  Ledger  after  the  nominal  or  subsidiary 
proprietorship  accounts  have  been  closed  directly  into 
the  Proprietor's  Account  or  into  some  main  subdivision 
of  that  account. 

The  figures  which  appear  in  a  balance  sheet  are  taken 
from  the  general  ledger  accounts.  This  must  be  borne 
in  mind,  since  in  a  later  chapter  we  shall  discuss  similar 
exhibits  which  are  not  balance  sheets,  simply  because 
they  do  not  obtain  their  figures  from  the  General  Ledger. 

The  difference  between  a  trial  balance  and  a  balance 
sheet  is  that  a  trial  balance  is  taken  from  the  Ledger 
before  the  nominal  accounts  have  been  closed;  a  balance 
sheet  is  taken  from  the  Ledger  after  the  nominal  accounts 
have  been  closed. 

FOKM  OF  BALANCE  SHEET 

It  is  not  essential  that  a  balance  sheet  be  in  trial  balance 
form.  Some  latitude  as  to  arrangement  of  the  figures 
is  permissible;  thus,  the  above  balance  sheet  may  be 
presented  in  other  forms  and  still  be  correctly  termed 
a  "balance  sheet" 


114  Principles  of  Accounting 

BALANCE  SHEET — ARTHUR  B.  CLARK 
December  31,  1915 

Assets 

Cash  $3,263.78 

Accounts   Beceivable 340.00 

Notes    Receivable 1,050.00 

Merchandise  Inventory,  Dec.  31,  1915 4,500.00 

Total  Current  Assets $9,153.78 

Furniture  &  Fixtures. .  400.00 


Assets $9,553.78 


Accounts  Payable 306.47 

Net  Resources 9,247.31 

Represented  by — 

A.  B.  C3ark — Capital  Invested $9,000.00 

Profits— period  ended  Dec.  31,  1915 247.31     $9,247.31 

There  are  several  other  standard  methods  of  arrange- 
ment and  presentation  of  balance  sheets.  A  more  detailed 
discussion  of  proper  balance  sheet  construction  will 
appear  later  in  this  chapter. 

English  accountants  regard  the  balance  sheet  as  a 
statement  of  account  rendered  by  the  business  to  the 
proprietor.  This  is  a  strictly  logical,  but  somewhat  nar- 
row, point  of  view.  A  balance  sheet  is  of  interest  to 
three  classes  of  persons: 

1.  The  proprietor  of  the  business. 

2.  The  creditors  of  the  business. 

3.  The  management  of  the  business. 

The  proprietor's  interest  in  the  balance  sheet  is  evi- 
dent. He  has  invested  his  money  in  the  business  and  is 
entitled  to  know  what  is  happening  to  it,  whether  it  is 
being  increased  through  wise  management  or  decreased 
through  poor  judgment  and  extravagance. 


Balance  Sheet  115 

The  one  who  extends  credit  to  a  business  is  also  entitled 
to  know  whether  his  interests  are  properly  safeguarded. 
The  yearly  balance  sheet  affords  him  an  opportunity  to 
confirm  his  good  judgment  in  extending  the  credit  and 
to  offer  further  accommodations  if  it  seems  wise.  Most 
creditors  are  now  demanding  yearly  copies  of  their  cus- 
tomer's balance  sheets,  and  that  debtor  who  will  not 
furnish  them  must  be  in  a  very  strong  financial  position 
to  escape  the  suspicion  that  he  has  something  to  conceal 
from  his  creditors. 

It  is  to  the  manager  that  this  exhibit  is  of  greatest 
value.  It  gives  him  a  bird's-eye  view  of  the  condition 
of  the  business  at  a  given  time,  and  a  comparison  of  this 
with  similar  statements  of  previous  years  affords  invalu- 
able information  as  to  the  progress  made.  Based  on 
such  significant  history  as  is  afforded  by  these  compara- 
tive statements,  the  manager's  plans  for  the  future  are 
formulated. 

LIMITATIONS  OF  THE  BALANCE  SHEET 

A  balance  sheet  may  be  compared  to  a  snapshot 
photograph  of  an  object.  It  is  a  "still"  picture  and, 
therefore,  does  not  tell  a  complete  story.  No  element 
of  action  is  present,  and  action  is  the  most  noticeable 
characteristic  of  a  business.  At  every  tick  of  the  clock 
some  change  takes  place.  Assets  are  constantly  altering 
in  value — either  depreciating  or  appreciating.  Every 
turn  of  a  wheel  in  the  shop,  every  shovel  of  coal  in  the 
boiler,  every  ounce  of  a  workman's  energy  has  its  own 
direct  influence  on  the  values  of  the  business.  Every 
day  may  see  hundreds  and  thousands  of  events  tending 
to  alter  the  previously  established  business  status.  Even 
at  the  dead  of  night  when  all  activity  has  apparently 
ceased,  there  are  powerful  and  inevitable  forces  at  work, 


116  Principles  of  Accounting 

increasing  and  decreasing  profits.  Interest  and  taxes 
accrue,  instant  by  instant — unexpired  insurance  is  les- 
sened with  every  swing  of  the  pendulum. 

If  it  were  humanly  possible  to  construct  balance  sheets 
with  microscopic  accuracy  and  to  draw  one  off  at  the  end 
of  every  hour  in  the  day,  it  would  still  be  impossible  to 
obtain  a  complete  running  history  of  the  business  from 
them.  How  much  more  crude  and  rough  are  the  results 
when  a  balance  sheet  is  taken  from  the  books  once  a 
month  or  once  a  year. 

THE  WOKKING  BALANCE  SHEET 

In  analyzing  a  trial  balance  for  the  purpose  of  framing 
up  closing  journal  entries,  accountants  and  auditors  use 
a  working  sheet  or  working  balance  sheet,  which  is  very 
similar  to  the  six-column  statement  used  in  the  teaching 
of  bookkeeping.  As  an  introduction  to  the  working 
balance  sheet,  we  show  in  Figure  40  a  six-column  state- 
ment, using  the  trial  balance  already  given. 

Every  item  appearing  in  the  trial  balance  columns  may 
be  extended  into  the  other  columns.  The  only  difficulty 
is  to  select  the  proper  column.  Sometimes  the  amount 
has  to  be  split  between  two  columns,  as  in  the  case  of 
Furniture  and  Fixtures  Account,  which  stood  as  $450.00 
in  the  trial  balance  but,  because  of  a  lessening  in  value 
due  to  wear  and  tear,  the  items  were  really  worth  only 
$400.00.  This  figure  is  extended  into  the  "Assets" 
column  and  the  difference,  $50.00,  is  extended  into  the 
"Loss"  column.  Such  an  account  which  is  part  real  and 
part  nominal  is  known  as  a  "mixed  account."  Modern 
accountants  demand  the  elimination  of  the  mixed  account 
and  the  substitution  therefor  of  other  accounts  which 
are  unmixed. 

It  is  not  possible  to  avoid  mixed  accounts  absolutely, 


Balance  Sheet 


117 


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118  Principles  of  Accounting 

as  will  be  noted  from  the  illustration  of  the  Furniture 
and  Fixtures  Account.  If  the  value  of  this  asset  is 
lessening  day  by  day,  the  figure  of  $400.00,  which  was 
correct  on  Dec.  31,  will  be  untrue  on  Jan.  1,  and  still  less 
true  on  Jan.  2,  etc.  The  "asset"  element  is  continually 
diminishing  and  the  "loss"  element  increasing  at  the 
same  rate,  so  that  a  pure  asset  account  on  Dec.  31  has 
become  a  mixed  account  the  following  day. 

ADJUSTING  ENTRIES 

It  is  necessary,  therefore,  at  the  end  of  each  accounting 
period  to  make  certain  so-called  "adjusting  entries," 
which  transfer  the  nominal  element  of  "mixed"  accounts 
to  the  purely  nominal  accounts.  The  phrase  "adjusting 
entries"  also  is  applied  to  entries  for  the  correction  of 
errors,  either  clerical  or  otherwise.  These  adjusting 
entries  are  for  the  purpose  of  bringing  the  accounts  into 
agreement  with  the  facts.  Adjusting  entries  are  also 
used  to  handle  accruals.2 

These  various  adjusting  entries  should  all  be  made 
before  the  closing  entries  are  made,  and  a  sharp  distinc- 
tion drawn  between  the  two.  Adjusting  entries  are  for 
the  purpose  of  setting  up  accruals  and  of  correcting 
intentional  errors,  or  errors  of  omission,  commission,  or 
principle.  Closing  entries  are  used  solely  for  the  purpose 

2  The  Committee  on  Accounting  Terminology  of  the  American  Asso- 
ciation of  Public  Accountants  offers  the  following  authoritative  definitions: 
Accrual — (1)   The  act  of  accruing. 

(2)   That  portion  of  an  accruing  account  not  yet  due,  appli- 
cable to  the  accounts  of  the  period  under  consideration. 
Accrue — (1)   To  accumulate  automatically  through  the  lapse  of  time. 
(2)   To  set  up  or  record  a  debit  or  credit  automatically  accu- 
mulating through  lapse  of  time. 

Accrued  interest  receivable  or  payable — the  amount  of  accruals  of  inter- 
est on  various  classes  of  assets  or  liabilities. 

Accrued  taxes — the  amount  of  accruals  of  taxes. 


Balance  Sheet 


119 


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120 


Principles  of  Accounting 


of  transferring  balances  of  nominal  accounts  to  the  Pro- 
prietor 's  Account  or  one  of  its  main  subsidiaries. 

The  working  balance  sheet  which  modern  accountants 
and  auditors  employ  differs  from  the  simple  six-column 
statement  mainly  in  that  provision  is  made  for  handling 
adjustments.  A  simple  form  of  working  balance  sheet 
is  illustrated  in  Figure  41,  using  the  same  trial  balance 
as  before. 

As  a  further  illustration  of  the  principles  involved  in 
constructing  a  balance  sheet  from  a  given  trial  balance, 
the  following  problem  and  solution  are  offered: 


TRIAL  BALANCE — J.  J.  WILLIAMS 
December  31,  1915 

Debit  Credit 

Cash $     7,860.00 

Accounts   Receivable 32,550.00 

Merchandise  Inventory  1-1-15 22,000.00 

Furniture  &  Fixtures 3,300.00 

Accounts  Payable $     9,722.00 

Notes    Payable 12,000.00 

Williams— Capital  Account 19,824.00 

Sales    132,298.00 

Returned    Sales 2,619.00 

Interest   Earned 612.00 

Purchases    84,200.00 

Returned   Purchases 1,106.00 

Salesmen 's    Salaries 11,204.00 

Rent 600.00 

Salesmen 's    Expense 3,009.00 

Office  Salaries 4,032.00 

Office    Expense 1,618.00 

Interest  Expense 721.00 

Sales   Discount 1,849.00 


$175,562.00     $175,562.00 


Balance  Sheet  121 

INVENTORIES,  DECEMBER  31,  1915 

Merchandise   ...............................................  $25,180.00 

Bent  Paid  in  Advance  .......................................          55.00 

Taxes  Accrued  .............................................        290.00 

Office  Salaries  Due  but  Not  Paid  ..............................        263.00 

Interest  Accrued  on  Notes  Payable  ............................          96.00 

It  is  estimated  that  Furniture  and  Fixtures  have  depre- 
ciated about 


After  the  adjusting  entries  are  posted  a  trial  balance 
should  be  taken  of  the  Ledger.  This  trial  balance  will 
contain  the  same  figures  as  are  shown  in  columns  (5)  and 
(6)  of  the  working  balance  sheet  (Figure  42). 

The  next  step  is  to  make  and  post  the  closing  journal 
entries. 

EXPLANATION  OF  ADJUSTMENTS 

Adjustment  entry  (a)  is  for  the  purpose  of  setting 
up  the  new  inventory  ($25,180.00)  as  an  asset  and  elim- 
inating the  old  inventory  ($22,000.00).  In  journal  entry 
form  this  adjustment  would  appear  as  follows  : 

Dec.  31,  1915,  Merchandise  Inventory  12-31-15  ......  $25,180.00 

Profit  and  Loss  ................  $25,180.00 

Profit  and  Loss  .............  .......  22,000.00 

Merchandise  Inventory  1-1-15...  22,000.00 

or  better  still  the  following  form  : 

Dec.  31,  1915,  Merchandise  Inventory  12-31-15  .....  $25,180.00 

Merchandise  Inventory  1-1-15...  $22,000.00 

Profit  and  Loss  ................  3,180.00 

Adjustment  entry  (b)  is  for  the  purpose  of  setting 
up  Rent  Paid  in  Advance  ($55.00)  as  a  deferred  expense 
item  (an  asset).  This  is  the  same  as  $55.00  in  cash  so  far 
as  meeting  the  rent  expense  of  the  next  accounting  period 
is  concerned.  Because  it  was  paid  in  this  period  does 


122 


Principles  of  Accounting 


Accounts 


WORKING  BALANCE   SHEET 
As  of 

Trial  Balance  Adjustments 

(1)  (2)  (8)  (4) 


Cash  $     7,860.00 

Accounts  Eeceivable 32,550.00 

Merchandise  Inventory, 

1-1-15   22,000.00  $22,000.00(a) 

Furniture  &  Fixtures 3,300.00  330.00(f ) 

Accounts  Payable $    9,722.00 

Notes  Payable 12,000.00 

Williams'  Capital  Account  19,824.00 

Sales 132,298.00 

Returned  Sales 2,619.00 

Interest  Earned 612.00 

Purchases    84,200.00 

Returned    Purchases 1,106.00 

Rent  600.00  55.00(b) 

Salesmen 's    Salaries 11,204.00 

Salesmen 's  Expense 3,009.00 

Office    Salaries 4,032.00  .         $      263.00  (d) 

Office  Expense 1,618.00 

Interest   Expense 721.00  96.00  (e) 

Sales   Discount 1,849.00 

$175,562.00  $175,562.00 

Merchandise  Inventory, 

12-31-15  25,180.00  (a) 

Profit  and  Loss 22,000.00  25,180.00 (a) 

Rent  Paid  in  Advance. ...  55.00  (b) 

Taxes  290.00  (c) 

Taxes  Payable  Accrued..  290.00 (c) 
Accrued  Office  Salaries 

Payable  263.00(d) 

Accrued  Interest  Payable  96.00 (e) 
Depreciation  —  Furniture 

&    Fixtures 330.00                     (f) 


Net  Profit  to  Balance.. 


$48,214.00  $48,214.00 


FIG.  42. — Working  Balance  Sheet 


Balance  Sheet 


123 


— J.  J.  WILLIAMS 
December  81, 1915 

Trial  Balance  Assets,  Liabilities  and  Capital 
(5)                         (6)  (7)  (8) 

$    7,860.00  $  7,860.00 

32,550.00  32,550.00 


Loss  and  Gain 
(9)  (10) 


2,970.00 


2,970.00 


$  9,722.00 

$  9,722.00 

12,000.00 

12,000.00 

19,824.00 

19,824.00 

132,298.00 

2,619.00 

2,619.00 

612.00 

84,200.00 

84,200.00 

1,106.00 

545.00 

545.00 

11,204.00 

11,204.00 

3,009.00 

3,009.00 

4,295.00 

4,295.00 

1,618.00 

1,618.00 

817.00 

817.00 

1,849.00 

1,849.00 

$132,298.00 


612.00 


1,106.00 


25,180.00 

55.00 
290.00 


3,180.00 


290.00 


25,180.00 


55.00 


290.00 


290.00 


3,180.00 


330.00 


263.00 
96.00 


263.00 
96.00 


330.00 


$42,195.00     $110,776.00 
26,420.00         26,420.00 
$179,391.00     $179,391.00     $68,615.00     $68,615.00     $137,196.00     $137,196.00 


FIG.  42. — Continued 


124  Principles  of  Accounting 

not  mean  that  it  is  necessarily  chargeable  against  this 
period.  In  conventional  journal  entry  form  this  would 
appear  as  follows: 

Dec.  31,  1915,  Eent  Paid  in  Advance $55.00 

Eent  $55.00 

Adjustment  entry  (c)  is  for  the  purpose  of  setting 
up  an  accrued  liability.  If  the  tax  period  does  not  coin- 
cide with  the  accounting  period,  such  an  adjustment  will 
always  have  to  be  made;  otherwise  one  period  will  be 
unfairly  favored  at  the  expense  of  the  other.  Such  an 
item  as  this  is  a  liability  inventory. 

Journal  entry  form : 

Dec.  31, 1915,  Taxes $290.00 

Taxes  Payable  Accrued $290.00 

Adjustment  entry  (d)  is  for  the  purpose  of  setting  up 
as  a  liability  (an  account  payable)  the  amount  due  to 
office  employees  for  services,  but  unpaid  because  the  end 
of  the  accounting  period  (December  31)  came  before  the 
regular  pay  day. 

Journal  entry  form : 

Dec.  31,  1915,  Office  Salaries $263.00 

Accrued  Office  Salaries  Payable $263.00 

Adjustment  entry  (e)  is  for  the  purpose  of  setting  up 
as  a  liability  the  interest  accrued,  on  notes  payable. 
This  interest  must  be  paid  during  the  following  account- 
ing period,  but  it  is  chargeable  to  the  expenses  of  this 
accounting  period. 

Journal  entry  form: 

Dec.  31,  1915,  Interest  Expense $96.00 

Accrued  Interest  Payable $96.00 

Adjustment  entry  (f)  is  for  the  purpose  of  reducing 
the  value  of  the  asset  account,  Furniture  and  Fixtures, 


Balance  Sheet  125 

to  accord  with  its  estimated  loss.  This  amount  is 
chargeable  to  the  nominal  account.  "Depreciation — 
Furniture  and  Fixtures. " 

1915  CLOSING  JOURNAL  ENTRY 

Dee.  31     Sales   $132,298.00 

Interest   Earned 612.00 

Returned   Purchases 1,106.00 

Purchases    $84,200.00 

Eeturned  Sales 2,619.00 

Eent    545.00 

Salesmen 's  Salaries 11,204.00 

Salesmen 's  Expense 3,009.00 

Office   Salaries 4,295.00 

Office    Expense 1,618.00 

Interest   Expense 817.00 

Sales   Discount 1,849.00 

Taxes    290.00 

Depreciation — Furniture  &  Fixtures 330.00 

Profit  and  Loss 23,240.00 

After  this  entry  has  been  posted  the  balance  of  the 
Profit  and  Loss  Account  will  be  $26,420.00.  This  repre- 
sents the  profit  of  the  period  and  should  be  transferred  to 
the  Proprietor's  Account.  A  trial  balance  of  the  Ledger 
at  this  point  will  be,  in  reality,  a  balance  sheet. 

POST-CLOSING  TRIAL  BALANCE 

Debit  Credit 

Cash  $  7,860.00 

Accounts    Keceivable 32,550.00 

Furniture  &  Fixtures 2,970.00 

Merchandise    Inventory 25,180.00 

Kent  Paid  in  Advance 55.00 

Accounts  Payable $  9,722.00 

Notes    Payable 12,000.00 

J.    J.   Williams 46,244.00 

Taxes   Payable   Account 290.00 

Accrued  Office  Salaries  Payable 263.00 

Accrued  Interest  Payable 96.00 


$68,615.00     $68,615.00 


126 


Principles  of  Accounting 


From  these  unarranged  figures  the  finished  balance 
sheet  is  constructed  as  shown  in  Figure  43. 

UNDERLYING  PRINCIPLES 

From  the  problems  and  solutions  so  far  considered  cer- 
tain general  principles  may  be  derived.  These  governing 
principles  are  few  in  number  and  of  theoretical  simplicity, 


BALANCE  8HKR  —  /.  3.  WIUIAM3 
D*0.  81.    1915 


Cash 
Accounts  Receivable 
Merchandise  Inventory 
Total  Quick  Assets 
Furniture  i  Fixtures 
Deferred  Expense 
Other  Assets 

Total  Assets 

,  7.860 
38.550 
25.180 

00 
00 
00 

00 
00 

Accounts  Payable 
Hotes  Payable 
Accrued  Taxes  Payable 
Accrued  Office  Salaries  Payable 
Accrued  Interest  Payable 
Total  Current  Liabilities 
J.  J.  Williams  Cap.  Acct. 
net  Profit  for  the  Period 
Total  Proprietorship 
Total  Inabilities  and  Capital 

9.722 
12.000 
290 
263 
96 

00 
00 
00 

oo1 

00 

2.970 

55 

00 
00 

65.690 

19.624 
26.420 

00 
00 

E2.371 

46.244 

68.615 

"  '__'  ."I....'.'"'. 

3.025 

68.615 

00 

FIG.  43. — Balance  Sheet  of  J.  J.  Williams 

but  their  practical   application  is   oftentimes   difficult, 
owing  to  the  complexity  of  modern  accounting  practice. 

1.  An  asset  may  be  exchanged  for  another  asset  of  equal 
value  without  affecting  Proprietorship,  i.  e.,  Capital  In- 
vested, Expense,  and  Income  Accounts. 


(Example  A) 
TRIAL  BALANCE 


Debit 


Cash  $  1,000.00 

Land    5,000.00 

Other  Assets 10,000.00 

Expense    3,000.00 


$19,000.00 


Liability  $  2,000.00 

Capital  Invested 12,000.00 

Income    5,000.00 


$19,000.00 


Balance  Sheet 


127 


If  land  is  purchased  for  $600.00  in  cash,  Land  Account 
will  be  debited  for  $600.00  and  Cash  credited  for  $600.00 
with  the  following  result: 


TRIAL  BALANCE 


Debit 


Credit 


Cash  $      400.00 

Land    5,600.00 

Other  Assets 10,000.00 

Expense 3,000.00 


$19,000.00 


Liabilities $  2,000.00 

Capital  Invested 12,000.00 

Income    5,000.00 


$19,000.00 


This  change  took  place  without  affecting  proprietor- 
ship. The  principle  holds  good  in  this  simple  example 
and  is,  of  course,  equally  true  in  every  case  even  though 
there  might  be  a  large  number  of  subsidiary  proprietor- 
ship accounts,  L  e.,  nominal  accounts. 

2.  A  liability  may  be  exchanged  for  another  liability  of 
equal  amount  without  affecting  proprietorship. 

(Example  B) 
TRIAL  BALANCE 


Debit 


Credit 


Cash $  1,000.00 

Land   5,000.00 

Other  Assets 10,000.00 

Expense 3,000.00 


$19,000.00 


Accounts  Payable $  1,000.00 

Notes    Payable 1,000.00 

Capital  Invested 12,000.00 

Income    5,000.00 


$19,000.00 


One  of  the  accounts  payable  for  $100.00  may  be 
extinguished  by  issuing  a  note  for  the  same  amount. 
This  might  involve  a  debit  to  Accounts  Payable  and  a 
credit  to  Notes  Payable  for  $100.00.  After  this  entry 

is  been  made,  the  following  trial  balance  results : 


128 


Principles  of  Accounting 


TRIAL  BALANCE 


Debit 


Credit 


Cash $  1,000.00 

Land   5,000.00 

Other  Assets 10,000.00 

Expense    3,000.00 


$19,000.00 


Accounts  Payable $      900.00 

Notes  Payable 1,100.00 

Capital  Invested 12,000.00 

Income    5,000.00 


$19,000.00 


This  change  took  place  without  affecting  proprietor- 
ship. The  principle  holds  true  regardless  of  the  number 
or  kind  of  proprietorship  accounts. 

3.  An  asset  may  be  used  to  extinguish  a  liability  of 
equal  amount  without  affecting  proprietorship. 

(Example  C) 
TRIAL  BALANCE 


Debit 


Credit 


Cash $  1,000.00 

Land    5,000.00 

Other  Assets 10,000.00 

Expense 3,000.00 


$19,000.00 


Accounts  Payable .$  1,000.00 

Notes  Payable 1,000.00 

Capital  Invested 12,000.00 

Income 5,000.00 


$19,000.00 


If  $300.00  in  cash  is  used  to  settle  a  note  payable  of 
the  same  amount,  Cash  must  be  credited  and  Notes 
Payable  debited  for  $300.00.  The  resulting  trial  balance 
appears  as  follows: 


TRIAL  BALANCE 


Debit 


Credit 


Cash $     700.00 

Land    5,000.00 

Other  Assets 10,000.00 

Expense    3,000.00 


$18,700.00 


Accounts    Payable $  1,000.00 

Notes    Payable 700.00 

Capital  Invested 12,000.00 

Income 5,000.00 


$18,700.00 


Balance  Sheet  129 

Proprietorship  was  not  affected  by  this  change.  The 
principle  holds  true  regardless  of  the  number  or  kind 
of  proprietorship  accounts. 

4.  Every  change  in  the  status  of  general  ledger  ac- 
counts, except  the  three  above  noted,  must  affect  one  or 
more  of  the  proprietorship  accounts.     This  is  a  perfectly 
logical  conclusion,  since  by  the  fundamental  law  of  double 
entry  a  change  in  one  account  must  be  reflected  by  a 
counterbalancing  change  in  another.     There  are  only  two 
basic  classes   of  accounts — real  accounts  and  nominal 
accounts.     A  change  in  a  real  account  must,  therefore, 
be  balanced  by  an  opposite  equal  change  in  (1)  another 
real  account  or  (2)  a  nominal  account. 

5.  Whenever  a  real  account  is  credited,  extreme  care 
should  be  exercised  in  making  the  proper  debit.    If  a  real 
account  is  erroneously  debited  in  place  of  a  nominal 
account,  the  result  will  be  an  overstatement  of  assets 
resulting  in  an  overstatement  of  profits  (or  an  under- 
statement of  expense  which  amounts  to  the  same  thing). 
If  a  real  account  is  erroneously  credited  in  place  of  a 
nominal  account,  the  result  will  be  an  understatement  of 
assets  resulting  in  an  understatement  of  profit  (or  an 
overstatement  of  expenses  which  has  a  similar  effect). 

(Example  D) 

TKIAL  BALANCE 
Debit  Credit 


Cash $  1,000.00 

Land    5,000.00 

Other   Assets 10,000.00 

Expense 3,000.00 


$19,000.00 


Accounts   Payable $  1,000.00 

Notes  Payable 1,000.00 

Capital  Invested 12,000.00 

Income    5,000.00 


$19,000.00 


If  $250.00  in  cash  is  paid  for  salaries,  the  proper  book- 
g  is  to  credit  Cash  and  debit  Expense  (or  one  of  its 


130 


Principles  of  Accounting 


subsidiary  accounts).     This  would  be  reflected  in  the 
following  trial  balance: 


TRIAL  BALANCE 


Debit 


Credit 


Cash $      750.00 

Land    5,000.00 

Other   Assets 10,000.00 

Expense 3,250.00 


$19,000.00 


Accounts  Payable $  1,000.00 

Notes  Payable 1,000.00 

Capital    Invested 12,000.00 

Income    5,000.00 


$19,000.00 


But  if  an  error  is  made  and  in  place  of  debiting  Ex- 
pense, the  Land  Account  is  debited  instead,  the  trial 
balance  would  show  figures  as  follows: 


TRIAL  BALANCE 


Debit 


Credit 


Cash $      750.00 

Land    : 5,250.00 

Other   Assets 10,000.00 

Expense 3,000.00 


$19,000.00 


Accounts  Payable $  1,000.00 

Notes  Payable 1,000.00 

Capital  Invested 12,000.00 

Income    5,000.00 


$19,000.00 


The  error,  therefore,  has  caused  two  misstatements  in 
the  trial  balance — land  is  overstated  $250.00,  and  ex- 
pense is  understated  $250.00.  The  balance  sheet  made 
from  the  correct  trial  balance  would  appear  thus : 


CORRECT  BALANCE  SHEET 


Cash  $      750.00 

Land    5,000.00 

Other  Assets 10,000.00 


$15,750.00 


Accounts  Payable $  1,000.00 

Notes  Payable 1,000.00 

Capital  Invested 13,750.00 


$15,750.00 


Balance  Sliest 


131 


The  balance  sheet  resulting  from  the  incorrect  trial 
balance  must  itself  be  incorrect. 


INCORRECT  BALANCE  SHEET 


Cash  $      750.00 

Land    5,250.00 

Other   Assets 10,000.00 


$16,000.00 


Accounts   Payable $  1,000.00 

Notes    Payable 1,000.00 

Capital  Invested 14,000.00 


$16,000.00 


6.  Each  accounting  period  must  be  charged  with  only 
its  proper  proportion  of  expense  and  credited  with  only 
its  proper,  proportion  of  income. 

Suppose  that  a  certain  firm  has  an  excess  of  cash  and 
that  a  favorable  opportunity  is  offered  for  it  to  pay  its 
rent  for  five  years  in  advance,  the  total  amount  involved 
being  $500.00.  The  journal  entry  for  booking  this  trans- 
action would  be  as  follows : 

Expense    $500.00 

Cash    $500.00 

If,  at  the  end  of  the  accounting  period,  the  total  balance 
of  the  Expense  Account  were  to  be  transferred  to  the 
main  Proprietor's  Account  a  serious  mistake  would 
appear.  The  current  accounting  period  would  be  charged 
with  all  the  rent  for  the  whole  five  years,  and  the  four 
following  years  would  be  charged  with  none.  This  means 
that  the  profits  of  the  current  period  are  wrongfully 
reduced  by  $400.00  and  that  those  of  each  succeeding 
period  will  be  wrongfully  inflated  by  $100.00  each.  The 
comparison  of  the  results  of  successive  years  would  be 
valueless  if  the  profits  for  one  year  were  thus  robbed  in 
favor  of  other  periods.  The  proper  procedure  would 
be  to  distribute  this  $500.00  equitably  over  the  five 
accounting  periods.  Each  period  should  obviously  be 


132  Principles  of  Accounting 

charged  with  $100.00  rent.  The  proper  method  of 
handling  such  a  situation  on  the  books  would  be  to  take 
an  inventory  of  the  Expense  Account  at  the  end  of  each 
accounting  period  and  to  set  this  inventory  up  as  an 
asset.  Such  an  asset  is  usually  called  a  "  Deferred 
Asset,*'  or  a  "Deferred  Debit  Item,"  or  a  "Deferred 
Expense  Item." 

At  the  end  of  the  first  period,  the  inventory  indicated 
that  $400.00  of  the  Expense  Account  is  a  deferred  asset. 
An  adjusting  entry  is,  therefore,  made,  crediting  Expense 
and  debiting  Deferred  Expense. 

JOURNAL  ENTRY 

Deferred    Expense $400.00 

Expense    $400.00 

At  the  beginning  of  the  next  accounting  period,  i.  e., 
the  following  day,  a  reverse  entry  is  made  throwing 
Deferred  Expense  back  into  Expense. 

JOURNAL  ENTRY 

Expense    $400.00 

Deferred    Expense $400.00 

At  the  end  of  that  period  another  expense  inventory  is 
taken,  amounting  to  $300.00,  and  is  handled  in  the  same 
way.  This  is  continued  until  the  end  of  the  five  years. 
The  result  is  that  the  prepaid  expense  has  been  justly 
distributed  over  the  proper  accounting  periods  instead 
of  being  dumped  into  the  first  one. 

As  a  further  illustration,  it  often  happens  that  Insur- 
ance premiums  are  paid  in  advance.  Suppose  that  on 
September  1,  1915,  a  year's  policy  is  taken  out  and  the 
year's  premium  of  $48.00  is  paid  in  cash.  On  December 
31,  1915,  at  the  close  of  the  accounting  period,  it  would 
be  entirely  improper  to  consider  the  entire  $48.00  as 
an  expense.  Only  4/12  of  it,  or  $16.00,  should  be  so 


Balance  Sheet  133 

considered,  and  the  balance  of  $32.00  should  be  handled 
as  a  deferred  asset.  This  deferred  asset  will,  of  course, 
expire  in  the  following  period. 

Such  deferred  asset  accounts  as  have  been  discussed 
represent  the  prepayment  of  expense,  and  their  purpose 
is  to  adjust  properly  profits  between  the  various  account- 
ing periods.  They  represent  assets  since  they  are  the 
same  as  cash  in  so  far  as  meeting  future  expenses  is 
concerned. 

The  principle  which  we  have  elaborated  is  equally 
applicable  to  the  credit  side  of  the  books.  Income 
received  in  advance  must  not  be  absorbed  into  the  current 
period's  profits.  It  represents  an  advance  payment  and 
is  a  deferred  liability  until  it  is  earned. 

Accrued  assets  and  accrued  liabilities  are  just  the 
opposite  of  deferred  assets  and  deferred  liabilities  so 
far  as  their  creation  is  concerned. 

If  an  expense  is  paid  in  advance,  a  deferred  asset  is 
formed,  but  if  an  expense  belongs  to  a  period  and  has  not 
been  recorded,  an  accrued  liability  must  be  set  up.  The 
entry  in  such  a  case  is  to  debit  the  proper  expense  account 
and  to  credit  an  accrued  liability  account.  An  example 
of  this  is  seen  in  connection  with  taxes.  If  the  accounting 
period  does  not  coincide  with  the  tax  year,  part  of  the 
taxes  must  be  charged  against  one  accounting  period  and 
part  against  the  one  following.  Since  taxes  are  paid  at 
the  end  of  the  tax  year,  it  means  that  an  accrued  liability 
must  be  set  up  at  the  end  of  the  first  accounting  period. 

JOURNAL  ENTRY 

Taxes    (expense) $ 

Accrued  Taxes  Payable  (liability) $ 

This  entry  will  be  reversed  at  the  beginning  of  the 
following  fiscal  period. 


134  Principles  of  Accounting 

Deferred  liabilities  and  accrued  assets  are  opposite  in 
character  and  effect.  A  deferred  liability  relates  to 
income  received  before  it  is  earned,  while  an  accrued 
asset  indicates  that  income  has  been  earned  but  not 
received.  The  accrued  asset  will  be  set  up  by  means 
of  an  entry,  crediting  the  income  account  and  debiting 
the  accrued  asset  account. 

SUMMAKY 

The  most  important  use  of  an  accounting  system  is  that 
of  comparison.  The  figures  of  one  period  alone  mean 
little.  The  figures  of  successive  accounting  periods, 
when  arranged  in  comparative  form,  are  invaluable. 
The  importance  of  seeing  that  these  figures  represent  the 
truth  is  self-evident.  They  will  be  valueless  for  com- 
parative purposes,  unless  each  accounting  period  bears 
no  more  than  its  proper  share  of  expense  and  takes  credit 
for  no  more  than  its  proper  share  of  income.  They  will 
be  of  inestimable  value  if  the  accounting  rule  that ' '  every 
expense  shall  be  distributed  over  the  accounting  periods 
benefited  by  that  expense ' '  is  adhered  to. 

The  problems  used  so  far  in  this  chapter  have  been 
elementary  in  order  that  proper  presentations  of  the 
principle  might  not  be .  obscured.  Many  readers  will 
desire  to  follow  through  a  more  complex  set  of  figures, 
and  to  that  end  the  following  trial  balance  and  working 
balance  sheet  are  submitted. 

PROBLEM 

(Adapted  from  Michigan  C.  P.  A.  Examination, 
June  25, 1910) 

The  trial  balance  of  The  Michigan  Manufacturing 
Company's  General  Ledger  on  May  31,  1910,  appeared 
as  follows: 


Balance  Sheet 


135 


Debit  Credit 

Cash  on  Hand  and  in  Bank $       430.15 

Notes  Keceivable 7,907.62 

Customers '   Accounts 20,797.80 

Land  &  Buildings 35,333.83 

Machinery  &  Equipment 12,344.88 

Horses,  Wagons,  etc 1,265.40 

Power  Machinery  Co 727.77 

Inventory  of  Manufacturing  Materials  6-1-09 27,214.41 

Purchases  of  Manufacturing  Materials 106,634.12 

Miscellaneous  Factory  Supplies 1,631.09 

Productive   Labor 63,8-42.23 

Freight,  Express  and  Cartage  ' '  In  " 1,734.70 

Stable  Expense    1,694.11 

Miscellaneous  Non-Productive  Labor 1,993.50 

Fuel   5,554.82 

Insurance    3,872.32 

Eepairs  to   Machinery 507.73 

Water  Tax 140.53 

Advertising    378.58 

Discount   Allowed  to  Customers 3,362.19 

Postage    264.42 

Salaries    6,170.00 

Stationery  and  Office  Supplies 296.02 

Miscellaneous  Main  Office  Expense 241.08 

Interest  Paid 3,386.80 

Accrued  Pay  Kolls $       487.66 

Notes    Payable 22,344.81 

Accounts    Payable 5,512.34 

Sundry    Creditors 2,511.89 

Allowance  for  Bad  Debts 1,059.51 

Capital  Stock 85,000.00 

Sales    187,540.38 

Discounts  Earned  on  Purchases 2,081.59 

Interest    Earned 463.17 

Miscellaneous    Earnings 724.75 


$307,726.10     $307,726.10 

The  inventory  of  Manufacturing  Material  on  hand  May 
31,  1910,  was  $51,358.58;  of  Finished  Goods,  $3,210.00; 
of  Factory  Supplies,  $200.00 ;  of  Fuel,  $2,188.40 ;  of  Horse 
Feed,  $14.22;  and  of  Goods  in  Process,  $1,820.00.  The 


136 


Principles  of  Accounting 


WORKING  BALANCE  SHEET 
As  of 

Trial  Balance  Journal    Adjustments 

Dr.  Cr.                    Dr.                    Cr. 

Cash  on  Hand  and  In  Bank $       430.15  

Notes  Receivable   7.907.62  

Customers'  Accounts  20.797.80  

Land    and    Buildings 35,333.83 

Machinery  and  Equipment 12.344.88  

Horses.  Wagons,  etc 1.265.40  

Power  Machinery   Co 727.77  

Inventory  of  Mfg.  Materials  6-1-09..     27,214.41  $  27,214.41     (a) 

Purchases  of  Mfg.  Materials 106.634.12  106,634.12     (a) 

Miscellaneous  Factory   Supplies 1.631.09  ..- 200.00     (b) 

Productive   Labor    63,842.23  

Freight.   Express   and   Cartage   "In".       1.734.70  

Stable   Expense    1.694.11  14.22     (d) 

Miscellaneous  Non-Productlve   Labor.       1,993.50  

Fuel    5,554.82  2.188.40     (c) 

Insurance    3.872.32  1,720.18     (e) 

Repairs   to   Machinery 507.73  

Water  Tax  140.53  

Advertising     378.58  

Discount   Allowed    to   Customers 3.362.19  

Postage    264.42  

Salaries   6,170.00  

Stationery   and   Office   Supplies 296.02  

Miscellaneous  Main  Office  Expense..          241.08  

Interest  Paid    3.386.80        $       134.83        (f) 

Accrued  Pay  Rolls $       487.66        

Notes   Payable    22,344.81        v 

Accounts   Payable    5,512.34        

Sundry  Creditors   2,511.89        

Allowance  for  Bad  Debts 1.059.51        9,128.11     (h) 

Capital  Stock    85,000.00        

Sales    187.540.38        

Discounts  Earned   on   Purchases 2,081.59        

Interest  Earned 463.17        

Miscellaneous  Earnings   724.75        

$307.726.10  $307.720.10 

Ultimate  Credit  to  Trading  Account 3,210.00  (m) 

Ultimate  Credit  to  Mfg.    Account 1,820.00  (k) 

Manufacturing  Materials  Used. $82.489.95        (a) 

Inventory  of 

Manufacturing   Materials    5-31-10 51.358.58        .(a) 

Factory   Supplies  5-31-10 200.00        (b) 

Goods  In  Process... 1,820.00        (k) 

Fuel    5-31-1*    2,188.40        (c) 

Finished   Goods    3.210.00        (m? 

Horse  Feed  5-31-10   14.22        (d) 

Unexpired  Insurance  5-31-10 1.720.18        (e) 

Accrued  Interest  Payable 134.83  (f) 

Accrued  Taxes  Payable 376.75  (g) 

Taxes    376.75        (g) 

Bad  Debts   9,128.11        (h) 

Depreciation.     Mach.    and  Equip 1.234.49        (j) 

Allowance  for  Depredation. 

Machinery  and  Equipment 1.234.49  (J) 

Net  Profit  to  Balance 

$153,875.51  $153.875.51 


FIG.  44. — Working  Balance  Sheet 


Balance  Sheet 


137 


MICHIGAN  MANUFACTURING  COMPANY 
May  81,  1910 

Trial  Balance  After  Posting 

the  Journal  Adjustments              Losses                Gain*                 Assets            Liabilities 

Dr.  Cr. 

$        430.15         $        430.15         

7.907.62        7,907.62        

20,797.80         20.797.80         

35,333.83         35.333.83         

12.344.88        12.344.88        

1,265.40         1.265.40         

727.77        727.77        

1.431.09  $  1.431.09  

63,842.23  63,842.23  '.. 

1,734.70  1,734.70  

1,679.89  1,679.89  

1.993.50  1.993.50  

3,366.42  3,366.42  

2,152.14  2,152.14  

507.73        507.73        

140.53         140.53         

378.58  378.58  

3,362.19  3,362.19  

264.42  264.42  

6,170.00  6,170.00  

296.02         296.02         

241.08         241.08         

3.521.63         3,521.63         

$        487.66         $        487.66 

22,344.81         22,344.81 

5.512.34         5.512.34 

2.511.89         2,511.89 

10.187.62         10,187.62 

85,000.00         85,000.00 

187.540.3J'         $187,540.38         

2,081.59         2,081.59         

463.17         463.17         

724.75        724.75        

3.210.09        3.210.00        

1,820.00        1,820.00        

82,489.95         82,489.95         

51,358.58         51,358.58         .... 

200.00         200.00        

1,820.00         1.820.00         

2,188.40        2.188.40        

3.210.00        3.210.00        

14.22         14.22         

1.720.18        1.720.18        

134.83        134.83 

376.75        376.75 

376.75        376.75        

9,128.11 9.128.11        

1,234.49        1.234,49 

1,234.49         1.234.49 

11.528.44         11,528.44 

$323.630.28  $323.630.28         $195.839.89         $195.839.89         $139.318.83         $139.318.83 

FIG.  44. — Continued 


138 


Principles  of  Accounting 


unexpired  insurance  premiums  amounted  to  $1,720.18. 
The  accrued  interest  on  Notes  Payable  amounted  to 
$134.83,  and  the  accrued  taxes  amounted  to  $376.75. 

Of  the  Customers '  Accounts,  $9,128.11  was  very  doubt- 
ful of  collection.  Depreciation  of  10%  should  be  pro- 
vided on  Machinery  and  Equipment.  The  item,  Power 
Machinery  Co.  $727.77,  represents  an  advance  payment 
for  machinery  in  process  of  installation. 

With  the  working  balance  sheet  solution  (Figure  44) 
as  a  basis,  the  adjusting  entries  may  be  drafted,  entered 
in  the  Journal,  and  posted  to  the  Ledger. 


ADJUSTING  JOURNAL  ENTRIES 


L.  P.       Debit 


Credit 


1910 

May  31     Inventory  of  Manufacturing  Material 

5-31-10 (a)   $51,358.58 

Manufacturing    Materials   Used (a)     82,489.95 

Purchases  of  Manufacturing  Mate- 
rials   (a)  $106,634.12 

Inventory  of  Manufacturing  Mate- 
rials 6-1-09 (a)  27,214.41 

31     Inventory — Goods  in  Process  5-31-10.  (k)       1,820.00 
Ultimate   Credit  to   Manufacturing 

Accounts  s  (k)  1,820.00 

31     Inventory— Finished  Goods  5-31-10. .  (m)       3,210.00 
Ultimate       Credit       to       Trading 

Account  s  (m)  3,210.00 

31     Inventory— Factory  Supplies  5-31-10.  (b)          200.00 

Miscellaneous  Factory   Supplies. ..  (b)  200.00 

31     Inventory— Fuel    5-31-10 (c)       2,188.40 

Fuel  (c)  2,188.40 

"  For  the  purpose  of  ready  cross  reference  between  the  journal  entries  and 
the  working  balance  sheet  (Figure  44)  a  somewhat  artificial  plan  has  been  fol- 
lowed. In  actual  practice  the  adjusting  and  the  closing  entries  would  not  be 
separated  quite  as  distinctly  as  in  this  case  and  would  not  attempt  to  follow  the 
working  balance  sheet  as  closely.  The  purpose  of  the  latter  is  to  furnish  correct 
figures,  and  it  is  not  intended  to  control  the  arrangement  of  the  journal  entries 
themselves.  In  solving  this  problem  it  has  been  thought  best  to  "link-up"  the 
various  exhibits  as  closely  as  possible  for  the  convenience  of  the  reader. 


Balance  Sheet 


139 


ADJUSTING  JOURNAL  ENTRIES 

Date  L.  P.         Debit  Credit 

1910 

May  31     Inventory— Horse  Feed  5-31-10 (d)  14.22 

Stable    Expense (d)  14.22 

31     Unexpired    Insurance (e)       1,720.18 

Insurance    (e)  1,720.18 

31     Taxes (g)          376.75 

Accrued  Taxes  Payable (g)  376.75 

31     Bad  Debts (h)       9,128.11 

Allowances  for  Bad  Debts (h)  9,128.11 

31     Depreciation — Machinery     &     Equip- 
ment   (j)       1,234.49 

Allowance     for    Depreciation — Ma- 
chinery &  Equipment (j)  1,234.49 

31     Interest    Paid (f)          134.83 

Accrued  Interest  Payable (f)  134.83 

After  these  journal  entries  are  posted,  a  trial  balance 
of  the  Ledger  will  show  the  figures  contained  in  the  third 
pair  of  columns  in  the  working  balance  sheet. 

The  Ledger  is  now  adjusted  and  ready  to  receive  the 
closing  journal  entries,  which  are  made  from  the  figures 
shown  in  the  fourth  pair  of  columns  in  the  working 
balance  sheet. 


CLOSING  JOURNAL  ENTRIES 
Date 
1910 
May  31     Ultimate  Credit  to  Manufacturing 

Account  *    

Manufacturing  Account 

31     Manufacturing    Account 

Manufacturing  Materials  Used. 
Freight,    Express    and    Cartage 

"In"    

Productive   Labor 

Miscellaneous  Factory  Supplies. 
Miscellaneous        Non-Productive 

Labor    

Repairs  to  Machinery 


L,.  F. 


Debit 


$     1,820.00 
156,740.64 


Credit 


$     1,820.00 
82,489.95 

1,734.70 

63,842.23 

1,431.09 


1,993.50 
507.73 


4  See  the  footnote  to  Exhibit  of  Adjusting  Journal  Entries. 


140 


Principles  of  Accounting 


CLOSING  JOURNAL  ENTRIES 
Date  L.  F.         Debit  Credit 

1910 

May  31        Depreciation    —    Machinery    & 

Equipment    1,234.49 

Fuel    3,366.42 

Water  Tax 140.53 

Trading  Account 154,920.64 

Manufacturing    Account 154,920.64 

To  close  the  latter  account 

31     Sales 187,540.38 

Ultimate   Credit   to    Trading   Ac- 
count *   3,210.00 

Trading  Account 190,750.38 

31     Trading  Account 35,829.74 

Operating  Profit   and  Loss  Ac- 
count      35,829.74 

31     Operating  Profit  and  Loss  Account  9,029.99 

Advertising   378.58 

Salaries   6,170.00 

Stationery  &  Office  Supplies 296.02 

Stable   Expense 1,679.89 

Postage    264.42 

Miscellaneous    Main    Office    Ex- 
pense      241.08 

31     Operating  Profit  and  Loss  Account  26,799.75 
Profit  and  Loss  Allocation  Ac- 
count      26,799.75 

31     Purchase    Discounts 2,081.59 

Interest  Earned 463.17 

Miscellaneous  Earnings   724.75 

Sundry  Profit  and  Loss 3,269.51 

31     Sundry  Profit  and  Loss 18,540.82 

Insurance    2,152.14 

Discount  Allowed  to  Customers.  3,362.19 

Interest  Paid 3,521.63 

Taxes    376.75 

Bad  Debts 9,128.11 

31     Profit  and  Loss  Allocation  Account  15,271.31 

Sundry  Profit  and  Loss 15,271.31 

31     Profit  and  Loss  Allocation  Account  11,528.44 

Undivided  Profits   11,528.44 

This  entry  to  be  made  upon  au- 
thority of  the  Board  of  Directors. 

*  See  the  footnote  to  Exhibit  of  Adjusting  Journal  Entries. 


Balance  Sheet 


141 


If  it  is  assumed  that  the  directors  have  authorized  the 
last  entry,  a  trial  balance  of  the  Ledger  at  this  point  will 
appear  as  follows : 

Debit  Credit 

Cash    $       430.15 

Notes  Eeceivable 7,907.62 

Customers '  Accounts 20,797.80 

Land  &  Buildings  35,333.83 

Machinery  &  Equipment   12,344.88 

Horses,  Wagons,  etc 1,265.40 

Deposit  on  Machinery  (Power  Machinery  Co.) ....          727.77 

Inventory  of  Manufacturing  Materials 51,358.58 

Inventory  of  Factory  Supplies 200.00 

Inventory  of  Goods  in  Process 1,820.00 

Inventory  of  Fuel 2,188.40 

Inventory  of  Finished   Goods 3,210.00 

Inventory  of  Horse  Feed 14.22 

Unexpired  Insurance 1,720.18 

Accrued  Pay  Bolls $       487.68 

Notes  Payable  22,344.81 

Accounts  Payable   5,512.34 

Sundry  Creditors 2,511.89 

Allowance  for  Bad  Debts 10,187.62 

Capital   Stock    85,000.00 

Accrued  Interest  Payable 134.83 

Accrued  Taxes  Payable  376.75 

Allowance  for  Depreciation — Machinery  &  Equip- 
ment     1,234.49 

Undivided  Profits   11,528.44 


$139,318.83     $139,318.83 


This  exhibit,  which  we  have  called  a  "  trial  balance, " 
is,  in  reality,  an  after-closing  or  "post-closing"  trial 
balance.  Strictly  speaking,  a  balance  sheet  is  nothing 
more  nor  less  than  a  post-closing  trial  balance.  This  is 
a  highly  important  point  and  should  be  fully  understood 
by  the  student,  because  he  will  see  many  statements  or 
exhibits  labeled  "Balance  Sheet"  that  are  not  balance 


142 


Principles  of  Accounting 


sheets  within  this  strict  definition,  although  they  are 
balance  sheets  to  all  intents  and  purposes.  The  term 
"balance  sheet, "  as  it  is  used  most  commonly,  refers  to 
a  statement  or  exhibit  constructed  from  a  post-closing 
trial  balance.  Such  a  balance  sheet  is  shown  as  follows : 


BALABCE  SHEET 


ASSETS 

Current  and  trading  Assets 

Cash  on  Hand  and  in  Bank 

430 

15 

Accounts  Receivable              $20.797.60 

I,eee-*Allowance  for  Bad  Debta       10.187.68 

10.610 

18 

Motets  Receivable 

7,907 

62 

Finished  Goods—  Inventory 

3.210 

00 

68.157 

95 

Working  Assets 

Manufacturing  Material—  Inventory 

51.358 

58 

Goods  in  Process—  Inventory 

1.820 

00 

Factory  Supplies  —  Inventory 

200 

00 

* 

Fuel--  Inventory 

2,188 

40 

Horse  Peed--  Inventory 

14 

22 

55.581 

20 

Fixed  Assets 
Machinery  and  Equipment           $12.344.88 

Less—  Allowance  for  Depreciation     1,234.49 

11,110 

39 

727 

77 

land  &  Buildings 

35.333 

83 

Horses.  Wagons,  etc. 

1.265 

40 

48.431 

39 

Deferred  Expense  Item 
Unexplred  Insurance 

1.720 

18 

£127,896 

72 

FIG.  45. — Balance  Sheet  in  Account  Form 
FOEM    OF   THE   BALANCE    SHEET 

A  balance  sheet  may,  and  usually  does,  classify  and 
summarize  the  figures  given  by  the  post-closing  trial 
balance  in  an  endeavor  to  present  the  facts  and  tell  its 
story  in  the  most  effective  way.  There  are  almost  as 
many  ways  of  constructing  a  balance  sheet  as  there  are 
accountants,  but  there  are,  at  least,  two  forms  of  pre- 
sentation that  are  fairly  well  standardized.  The  first 
method  (Figure  45)  is  to  list  the  assets  in  the  order  of 
realization,  starting  with  the  most  liquid  asset  "cash," 
and  closing  with  deferred  expense  items  or  other  assets 
which  probably  will  never  be  realized  in  cash.  The 
liabilities  follow  the  same  order,  running  from  the  most 
current,  such  as  accounts  payable,  to  capital  invested 
which  probably  will  never  be  paid. 


Balance  Sheet 


143 


Quick  assets. 
Fixed  assets. 
Deferred  expense  items. 


Current  liabilities. 
Secured  liabilities. 
Capital  liabilities. 
Undivided  profits  or  surplus. 


VICHIGAM  MAMUPACTURIHG  COMPANY 


May  31 t  1910 


LIABILITIES  ANC  CAPITAL 

Current  Liabilities 

5,512 

34 

Accounts  Payable 

487 

66 

Accrued  Wages  Payable 
Accrued  Interest  Payable 

134 
376 

83 
75 

Accrued  Taxes  Payable 
Sundry  Creditors 
Rotes  Payable 

2,511 

22.344 

89 
81 

31.368 

28 

Capital  and  Undivided  Profits 

Capital  Stock  Outstanding 
Undivided  Profits 

86,000 
11.528 

00 
44 

96.528 

44 

$127.896 

72 

FIG.  45. — Continued 


The  second  standard  form  of  balance  sheet  arrange- 
ment (Figure  46)  is  almost  the  reverse  of  the  above. 


Fixed  assets. 
Quick  assets. 
Deferred  expense  items. 


Capital  liabilities. 
Secured  liabilities. 
Current  liabilities. 
Undivided  profits  or  surplus. 


Either  of  these  forms  permits  of  easy  comparison 
between  the  amount  of  quick  assets  and  current  liabilities, 
or  the  amount  of  fixed  assets  and  secured  and  capital 
liabilities.  If  the  "report  form"  of  balance  sheet 
(Figure  47)  is  adopted, 'it  is  customary  to  list  the  assets 
in  the  order  of  realization  and  the  liabilities  running  from 
current  to  permanent.  The  report  form  has  found  popu- 
larity due  to  the  ease  with  which  it  may  be  typewritten 
on  a  standard  carriage  machine. 


144  Principles  of  Accounting 

CONSTRUCTION  OF  THE  BALANCE  SHEET 

This  operation  of  remolding  and  reconstructing  the 
post-closing  trial  balance  into  the  finished  balance  sheet 


BALANCE  SHS33 


As  of 


ASSSTS 

Fixed  Assets 

Machinery  &  Eoulpment              |12.344.  88 

Less—Allowance  for  Depreciation      1,834.49 

11,110 

39 

Deposit  on  Machinery  Purchase 
Land  &  Buildings 

787 
35,333 

77 
83 

Horses.  Wagons,  etc 

1.265 

40 

48,437 

39 

Working  Assets 

Manufacturing  Material—Inventory 

61,368 

58 

Goods  in  Process  —  Inventory 

1.880 

00 

Factory  Supplies—  Inventory 
Fuel  —  Inventory 

800 
8,188 

00 
40 

Horse  Peed—  Inventory 

14 

22 

55.581 

20" 

Current  and  Trading  Assets 

Cash  on  Hand  and  in  Bank 

430 

15 

Accounts  Receivable               $20,797.80 

Less—  Allowance  for  Bad  Debts       10.187.62 

10.610 

18 

Finished  Goods—  Inventory 

7,907 
3.210 

62 

00 

22,157 

95 

Deferred  Expense  Items 

Unerpired  Insurance 

1,720 

18 

127.696 

72 

FIG.  46. — Balance  Sheet  in  Account  Form 

affords  the  accountant  an  excellent  opportunity  to  exhibit 
his  skill,  but  it  also  opens  the  way  to  serious  misrepre- 
sentation by  improper  classification.  For  example,  the 
post-closing  trial  balance  might  show  as  assets  "TT.  S. 
Steel  Corporation  bonds,  $1,000.00"  and  "Wild  Cat 
Mining  Co.  bonds,  $32,000.00."  If  the  accountant  is 
honest,  he  will  carry  them  separately  on  the  balance 
sheet,  but  if  he  is  morally  weak,  he  may  be  persuaded  to 
lump  the  two  items  for  balance  sheet  purposes  in  some 
such  way  as  this: 


U.  S.  Steel  Corporation  and  other  bonds $£3,000.00 


0.00 


Balance  Sheet 


145 


This  would  be  strictly  true  but  very  misleading  to  the 
balance  sheet  readers,  i.  e.,  the  stockholders  or  creditors 
of  the  company. 


MICHIGAN  IUHUFAC TURING  COMPANY" 


May  31.    1910 


LIABILITIES  AMD  CAPITAX 

Capital  Invested 
Capital  stock  Outstanding 

85,000 

00. 

Current  Liabilities 
Notes  Payable 
Accounts  Payable 
Sundry  Creditors 
Accrued  Wages  Payable 
Accrued  Interest  Payable 
Accrued  Taxes  Payable 

Surplus  and  Undivided  Profits 
Undivided  Profits 

£2.344 
5.512 
8,511 
487 
134 
376 

81 
34 

89 
66 
83 
75 

31.368 
11.528 

28 
44 

127  896 

78 

TIG.  46. — Continued 

The  fine  points  of  balance  sheet  construction  and  pres- 
entation can  best  be  learned  by  the  consistent  study  of 
corporation  balance  sheets,  as  published  in  the  financial 
manuals,  financial  journals,  and  yearly  reports.  Such 
manuals,  journals,  and  reports  are  to  be  found  in  any 
good  public  library. 

THE  SEVEN  STEPS 

The  steps  involved  in  making  up  a  balance  sheet  are 
seven  in  number. 

1.  Take  a  trial  balance  of  the  General  Ledger  after  all 
postings  for  the  accounting  period  have  been  made. 

2.  Draw  up  a  working  balance  sheet  in  the  form  sug- 


146 


Principles  of  Accounting 


MICHIGAN  MANUFACTURING  COMPANY 
Balance  Sheet  a*  of  May  31,  1910 


ASSETS 

Current  and  Trading  Assets 
Cash  oa  Hand  and  in  Bank 

430 

L5 

A«oounts  Receivable                 £0,797.80 

Less  -  Allowance  for  Bad  Debts       10-,  1617.  62 

10,610 

18 

Ictea  Receivable 

7,907 

62 

Finished  Goods  -  Inventory 

3,210 

00 

Total  Current  and  Trading  Assets 

22,1§7 

95 

Working  Assets 

Manufacturing  Material  -  Inventory 

51,368 

58 

Goods  in  Process  -  Inventory 

1,820. 

00 

Factory  Supplies  -  Inventory 

200 

00 

Fuel  -  inventory 

2,188 

40 

Sorse   Feed  -  Inventory 
Total  Working  Assets 

14 

22 

55,581 

20 

Fixed  Assets 

Machinery  it  Equipment               IB  ,344.  88 

Less  -  Allowance  for  Depreciation     1,234.49 

11,110 

39 

727 

77 

Land  &  Buildings 

35,333 

83 

Horses,  Wagons,  etc. 
Total  Fixed  Assets 

1,265 

40 

4ft  437 

39 

Deferred  Expense  Items 

%&  ,  to  * 

Uoexpired  Insurance 

1*720 

18 

Total  of  All  Assets 

127,896 

72 

LIABILITIES 

Current  Liabilities 

Accounts  Payable 

5,512 

34 

Accrued  Wages  Payable 
Accrued  Interest  Payable 

487 
134 

66 
83 

Accrued  Taxes  Payable 

376 

75 

Sundry  Creditors 

2,511 

89 

Votes  Payable 

22,344 

81 

Total  Liabilities 

31,368 

28 

Net  Worth 

96,528 

44 

Represented  by 

Capital  Stock  Outstanding 

85,000 

00 

Undivided  Profits 

11,528 

.44 

96,588 

44 

FIG.  47. — Balance  Sheet  in  Keport  Form 

gested,  making  the  adjusting  entries  and  distributing  the 
resulting  figures  into  the  four  columns : 


1.  Loss. 

2.  Gain. 

3.  Asset. 

4.  Liability. 


Then  foot  all  columns  and  prove  the  accuracy  of  the 
work  by  comparing  the  debit  and  credit  footings  of  the1 


Balance  Sheet  147 

"Journal  Adjustment "  columns,  which  should  be  equal, 
and  by  adding  the  footing  of  the  "Loss"  and  " Assets " 
columns  and  comparing  that  total  with  the  sum  of  the 
footings  of  the  "Gain"  and  "Liability"  columns.  The 
sum  of  "Losses"  and  "Assets"  should  equal  the  sum  of 
"Gains"  and  "Liabilities." 

3.  Construct,  enter,  and  post  to  the  Ledger  the  adjust- 
ing journal  entries. 

4.  Construct,  enter,  and  post  the  closing  journal  entries. 
These  closing  journal  entries  should  debit  all  nominal 
accounts  with  credit  balances   and  credit  all  nominal 
accounts  with  debit  balances.     The  contra  entries  go  to 
intermediate  proprietary  accounts,  such  as  the  Manu- 
facturing Account,  Trading  Account,  Operating  Profit 
and  Loss  Account,  Miscellaneous  Profit  and  Loss  Account, 
and   Profit   and   Loss   Allocation   Account.     It   is   not 
strictly   necessary   to   close    the    nominal   accounts   by 
sections,  since  all  the  items  may  be  transferred  direct  to 
the  Profit  and  Loss  Account.     It  is  considered  much 
better  practice,  however,  to  close  out  the  various  loss 
and  gain  accounts  by  classes.     (See  Chapter  VII.)     The 
figures  to  be  used  in  the  closing  journal  entries  may  be 
obtained  from  the  "Loss"  and  "Gain"  columns  on  the 
working  balance  sheet. 

5.  All  balancing  accounts   are  ruled   off.    All  other 
accounts  are  balanced  and  brought  forward. 

6.  A  post-closing  trial  balance  is  taken  from  the  Ledger. 

7.  A  balance  sheet  is  constructed  from  the  post-closing 
trial  balance. 

NATURE  OF  DEPRECIATION 

The  balance  sheet,  at  best,  is  no  more  than  an  approxi- 
mation. It  cannot  even  tell  the  exact  truth.  It  is  nothing 
more  than  a  guess  at  the  truth,  albeit,  a  scientific  guess. 


148  Principles  of  Accounting 

It  wanders  farthest  from  accuracy  in  its  representations 
as  to  the  values  of  fixed  assets,  such  as  buildings  and 
machinery;  it  is  approximately  accurate  as  to  the  value 
of  working  assets  such  as  inventories  of  raw  material, 
semi-finished  and  finished  goods,  and  its  figures  as  to 
cash  should  be  absolutely  true. 

The  reason  for  these  unavoidable  inaccuracies  is 
obvious.  Suppose  a  machine  is  bought  new  for  $10,- 
000.00.  The  proper  entry  is: 

Machinery    $10,000.00 

Cash    $10,000.00 

At  the  end  of  the  year  the  trial  balance  shows 
"Machinery  $10,000.00. > '  If  it  is  assumed  that  the  ma- 
chine was  worth  $10,000.00  new,  is  it  still  worth  $10,000.00 
at  the  end  of  the  accounting  period? 

The  machine  has  been  operated  steadily,  it  is  slightly 
worn,  some  of  the  paint  has  been  scratched — it  has 
undoubtedly  deteriorated.  It  is  no  longer  worth 
$10,000.00. 

What  is  it  worth? 

That  is  an  important  question  and  one  that  no  person 
can  ever  answer  with  absolute  accuracy.  One  man's 
guess  may  be  as  good  as  another's.  The  junk  man  will 
only  pay  a  few  hundred  dollars  for  it.  The  second-hand 
machinery  dealer  will  pay  $4,000.00  for  it.  Another 
manufacturer  might  pay  $6,000.00  for  it.  Its  value  to  the 
company  itself  is  approximately  the  same  as  at  date  of 
purchase. 

Whatever  value  is  assigned  to  it  is,  at  best,  no  more 
than  an  expert  guess.  There  are  a  number  of  different 
methods  of  estimating  its  value  at  a  given  time,  and 
these  will  be  discussed  more  fully  in  Chapter  XII.  One 
way  is  to  estimate  the  "life"  of  the  machine,  that  is,  the 


Balance  Sheet  149 

length  of  time  it  will  last.  Such  an  estimate  should  be 
based  on  experience.  If  a  hundred  manufacturers  have 
found  that  it  was  not  necessary  to  "scrap"  and  replace 
similar  machines  until  they  were  nine  years  old,  at  which 
time  the  machines  could  be  sold  for  an  average  of 
$1,000.00  each,  sufficient  evidence  is  at  hand  to  warrant  a 
guess  that  this  particular  machine  will  last  nine  years  and 
will  have  a  remainder  value  of  $1,000.00. 

If  the  machine  is  worth  $10,000.00  when  purchased  and 
$1,000.00  nine  years  hence,  it  is  plain  that  it  has  lost 
$9,000.00  value  in  nine  years.  What  is  more  natural  than 
to  say  that  its  loss  in  value  is  $1,000.00  per  year? 

Value  =  $10,000.00  when  purchased. 

Value  =  9,000.00  end  of  first  year. 

Value  =  8,000.00  end  of  second  year. 

Value  —  7,000.00  end  of  third  year. 

Value  =  6,000.00  end  of  fourth  year. 

Value  =  5,000.00  end  of  fifth  year. 

Value  =  4,000.00  end  of  sixth  year. 

Value  =  3,000.00  end  of  seventh  year. 

Value  —  2,000.00  end  of  eighth  year. 

Value  =  1,000.00  end  of  ninth  year. 

At  the  end  of  each  year  an  adjusting  journal  entry  will 
be  made,  debiting  the  nominal  account,  "Depreciation," 
and  crediting  the  asset  account,  ' '  Machinery. ' '  The  clos- 
ing entry  will  then  throw  the  balance  of  the  Depreciation 
Account  into  Profit  and  Loss  where  it  will  serve  to 
reduce  the  credit  balance,  or  profit,  of  the  year.  At  the 
end  of  the  ninth  year  the  Machinery  Account  might 
appear  as  shown  in  Figure  48. 

On  January  1,  1909,  this  asset  of  "machinery"  will 
appear  on  the  balance  sheet  as  being  worth  $7,000.00,  but 
this  is  a  crude  guess  after  all.  The  only  two  times  that 


150 


Principles  of  Accounting 


MACHINERY  ACCOUNT 


1906 

Jan.  1  Purchased $10,000*00 


$10,000.00 

1907 

Jan.  1  Balance  forwarded.. $  9,000.00 


$  9,000.00 

1908 

Jan.  1  Balance  forwarded.. $  8,000.00 


$  8,000.00 

1909 

Jan.  1  Balance  forwarded.. $  7,000.00 


$  7,000.00 

1910 

Jan.  1  Balance  forwarded.  .$  6,000.00 


$  6,000.00 

1911 

Jan.  1  Balance  forwarded.. $  5,000.00 


$  5,000.00 

1912 

Jan.  1  Balance  forwarded.. $  4,000.00 


$  4,000.00 

1913 

Jan.  1  Balance  forwarded.. $  3,000.00 


$  3,000.00 

1914 

Jan.  1  Balance  forwarded.  .$  2,000.00 


$  2,000.00 


1915 

Jan.  1  Balance  forwarded.. $  1,000.00 


1906 

Dec.  31   Depreciation   $  1,000.00 

31   Balance  f orwarded. .  9,000.00 

$1Q,000.00 

1907 

Dec.  31   Depreciation    $  1,000.00 

31   Balance  f  orwarded. .  8,000.00 

$  9,000.00 


1908 

Dec.  31   Depreciation    $  1,000.00 

31   Balance  f  orwarded. .      7,000.00 


$  8,000.00 

1909 

Dec.  31   Depreciation    $  1,000.00 

31   Balance  forwarded. .     6,000.00 


$  7,000.00 

1910 

Dec.  31   Depreciation    $  1,000.00 

31   Balance  forwarded ..     5,000.00 


$  6,000.00 

1911 

Dec.  31   Depreciation    $  1,000.00 

31   Balance  f  orwarded.  .      4,000.00 

$  5,000.00 


1912 

Dec.  31   Depreciation    $  1,000.00 

31   Balance  forwarded..      3,000.00 


$  4,000.00 

1913 

Dec.  31   Depreciation    $  1,000.00 

31   Balance  f  orwarded.  .  2,000.00 


$  3,000.00 

1914 

Dec.  31   Depreciation    $  1,000.00 

31   Balance  f  orwarded. .  1,000.00 


$  2,000.00 


FIG.  48. — Machinery  Account 


Balance  Sheet  151 

the  value  of  the  machine  will  be  actually  known  is  at  the 
time  of  purchase  and  at  the  time  when  it  is  sold  for 
scrap.  It  is  convenient  for  bookkeeping  purposes  to  say 
that  its  value  decreases  uniformly  each  year,  but  few 
would  claim  it  strictly  true.  Many  assets  other  than 
machinery  are  just  as  difficult  to  value  correctly,  the 
result  being  that  many  accounts  do  not  show  the  truth. 
The  proprietary  accounts  will  be  out  of  agreement  with 
facts  by  the  net  amount  that  the  other  accounts  are 
inaccurate. 

Eecognizing  the  foregoing  arguments,  the  modern 
accountant  does  not  attempt  the  impossible.  It  is  now 
almost  universally  the  rule  to  charge  the  asset  account 
with  the  cost  of  the  asset,  leaving  that  figure  unchanged 
until  the  business  has  parted  with  it.  Instead  of  credit- 
ing the  asset  account  itself  each  year  with  a  figure 
supposed  to  represent  the  amount  of  value  which  the 
asset  has  lost,  a  separate  and  distinct  account  is  created 
to  receive  such  credits.  This  account5  may  be  called 
" Depreciation  Not  Written  Off"  or  "Allowance  for 
Depreciation."  It  really  takes  the  place  of  the  credit 
side  of  the  asset  account  and  is  called  a  "valuation 
account, ' ' 

By  using  an  Allowance  for  Depreciation  Account  to 
register  the  shrinkage  in  value  of  the  $10,000.00  machine, 
the  following  situation  appears  at  the  end  of  nine  years : 

MACHINERY  ACCOUNT 


1906 

Jan.  1 $10,000.00 


6  The  term  ' '  Reserve  for  Depreciation ' '  is  often  erroneously  used  in 
this  connection.     See  page  333. 


152 


Principles  of  Accounting 


ALLOWANCE  FOE  DEPRECIATION  ACCOUNT 


1906 

Dec.  31 

Depreciation  . 

..J 

$1,000.00 

1907 

Dec.  31 

Depreciation  . 

..J 

.1,000.00 

1908 

Dec.  31 

Depreciation  . 

..J 

1,000.00 

1909 

Dec.  31 

Depreciation  . 

..J 

1,000.00 

1910 

Dec.  31 

Depreciation  . 

..J 

1,000.00 

1911 

Dec.  31 

Depreciation  . 

..J 

1,000.00 

1912 

Dec.  31 

Depreciation  . 

..J 

1,000.00 

1913 

Dec.  31 

Depreciation  . 

..J 

1,000.00 

1914 

' 

Dec.  31 

Depreciation  . 

..J 

1,000.00 

The  difference  at  any  time  between  the  asset  account 
and  the  Allowance  for  Depreciation  Account  is  approxi- 
mately equal  to  the  value  of  the  asset  itself  at  that  time. 
The  asset  account  represents  the  original  cost  and  the 
Allowance  for  Depreciation  Account  represents  the 
approximate  diminution  in  the  value  of  the  asset. 

The  reader  should  bear  in  mind,  therefore,  that  asset 
accounts  usually  reflect  the  cost  of  the  assets  when  pur- 
chased and  that  any  particular  asset  account  conveys  no 
information  as  to  the  present  worth  of  the  asset  until  the 
proper  Allowance  for  Depreciation  is  deducted  from  it. 
Even  then  it  cannot  state  the  exact  truth,  since  the 
shrinkage  in  value  of  the  asset,  as  registered  in  the 
Allowance  for  Depreciation  Account,  is  only  an  estimate 
at  best,  being  a  doubt  cast  as  to  the  accuracy  of  the  asset 
account. 

INCOMPLETE  DOUBLE  ENTKY 

In  a  system  of  incomplete  double  entry  or  single  entry 
it  is  impossible  to  obtain  a  balance  sheet.  A  substitute 


Balance  Sheet  153 

for  the  balance  sheet  is  seen  in  the  exhibit  known  as  the 
"Statement  of  Resources  and  Liabilities. "  This  state- 
ment is  not  drawn  from  the  books  as  is  the  balance  sheet. 
It  is  nothing  more  than  a  list  or  written  inventory  of  the 
various  items  of  assets  and  liabilities  and  may  be  made 
independently  of  the  records.  The  arrangement  of  such 
a  statement  may  be  identical  with  that  of  a  balance  sheet, 
and  it  may  be  more  accurate.  But,  as  a  general  rule,  a 
post-closing  trial  balance  of  a  double  entry  Ledger, 
rearranged  and  properly  classified  in  balance  sheet  form, 
is  to  be  preferred  because  it  is  supported  by  all  the 
records,  journals,  and  subsidiary  ledgers.  It  is  thus 
subject  to  verification  or  audit. 

CONCLUSION 

Under  the  elementary  system  of  accounts,  proposed  in 
Chapter  I,  where  every  loss  is  debited  to  the  Proprietor's 
Account  as  soon  as  the  loss  occurs  and  every  gain  is 
credited  to  that  account  when  the  gain  is  made,  the  trial 
balance  will  always  show  exactly  the  same  figures  as  the 
balance  sheet.  With  such  a  system  all  changes  in  the 
assets  and  liabilities  are  permanently  recorded  when  they 
happen.  Therefore,  the  balance  of  the  Proprietor's 
Account  at  any  time  represents  the  amount  due  to  the 
proprietor  by  the  business. 

Such  a  simple  system  involves  no  adjusting  entries 
because  the  adjustments  are  made  day  by  day.  It  calls 
for  no  closing  entries  because  there  is  but  one  Proprie- 
tor's Account. 

When  the  Proprietor's  Account  is  split  up  into 
numerous  classified  subaccounts  (nominal  accounts),  and 
when  adjustments  are  not  made  day  by  day,  it  becomes 
necessary  to  obtain  the  facts  at  the  close  of  certain 
periods,  known  as  ' '  accounting  periods. ' '  At  the  end  of 


154  Principles  of  Accounting 

one  of  these  periods  adjustments  are  made  and  the 
nominal,  or  sub-proprietary,  accounts  are  closed  into 
the  one  main  account  representing  the  proprietor's 
interest. 

If  a  man  carries  all  his  money  in  one  pocket,  he  will 
have  no  difficulty  in  determining  his  financial  standing 
at  any  time.  If  he  has  twenty  pockets  each  containing 
money,  he  cannot  determine  what  the  total  is  at  any  time 
but  must  wait  until  he  can  transfer  the  money  from 
all  the  various  pockets  into  one  pile.  The  several  expense 
and  income  accounts  correspond  to  the  different  pockets 
. — the  net  figure  representing  loss  or  gain  for  the  period 
cannot  be  ascertained  until  the  various  expense  and 
income  items  are  brought  together. 

TEST  QUESTIONS 

1.  Why  may  a  prepaid  expense  be  considered  in  the  nature 
of  an  asset? 

2.  Why  is  it  impossible  to  obtain  a  balance  sheet  in  a  single 
entry  system? 

3.  Suppose  an  expense  account  is  improperly  charged  instead 
of  an  asset  account.     What  will  be  the  effect  on  the  balance 
sheet?    On  the  net  profit? 

4.  What  is  an  accrued  liability?     A  deferred  asset?    A  de- 
ferred liability?    An  accrued  asset? 

5.  What  are  the  seven  steps  leading  up  to  a  balance  sheet? 


CHAPTER  V 

ASSETS  AND  THEIR   VALUATION 

The  preceding  chapters  have  developed  the  fact  that 
the  left-hand  side  of  a  properly  arranged  balance  sheet 
is  made  up  of  assets  and  deferred  charges,1  and  it  has 
already  been  hinted  that  the  assets  differ  from  one  an- 
other in  (1)  nature,  (2)  ease  of  liquidation,  and  (3) 
accuracy  of  valuation. 

Some  writers  make  a  fundamental  distinction  between 
assets,  asserting  that  any  asset  must  represent  either 
actual  property  owned  or  valid  and  enforceable  claims  to 
property. 

This  distinction  is  unquestionably  sound.  A  man's 
house  and  lot  differ  fundamentally  from  accounts  receiv- 
able, notes  receivable,  or  other  forms  of  claim  which  he 
also  regards  as  assets.  However,  a  valid  and  enforceable 
claim  to  property  is,  under  modern  economic  conditions, 
fully  as  valuable  as  the  property  itself.  Such  a  claim  is 
often  negotiable  in  its  nature.  That  is,  it  may  be  passed 
from  one  person  to  another  by  indorsement  or  by  mere 
delivery  to  effect  a  negotiation.  An  example  of  such  a 
negotiable  claim  is  the  bank  check,  promissory  note,  or 
accepted  draft.  It  is  characteristic  of  such  a  negotiable 
claim  that  it  is  represented  by  a  document  of  some  sort. 

1  To  make  this  statement  inclusive  it  should  be  amended  to  read  * '  assets, 
deferred  charges,  and  losses  not  written  off."  It  occasionally  happens  that 
an  extraordinary  loss  is  allowed  to  stand  on  the  books  with  the  idea  of  writ- 
ing it  off  from  year  to  year  out  of  profits.  If  such  a  loss  item  is  clearly 
labeled,  it  may  properly  be  shown  on  the  asset  side,  although  it  is  actually 
a  valuation  account  offsetting  the  capital  accounts. 

155 


156  Principles  of  Accounting 

A  non-negotiable  claim  may,  nevertheless,  have  approx- 
imately equal  convertibility  to  a  negotiable  instrument. 
A  good  example  of  such  a  claim  is  an  ordinary  debt 
receivable,  which  is  often  no  more  than  an  implied 
promise  on  the  part  of  one  person  to  deliver  property, 
usually  cash,  to  another  person.2 

Such  a  claim  to  property,  owing  to  the  convenience 
with  which  it  may  be  turned  into  property,  is  properly 
regarded  as  the  equivalent  of  property.  Any  extended 
treatment  of  this  subject  would  involve  an  examination 
of  the  nature  of  credit,  which  seems  hardly  desirable 
here. 

Money  is  the  universal  medium  of  exchange.  All 
property  is  commonly  translated  into  terms  of  money- 
its  value  is  estimated  in  dollars  and  cents.  Money  itself, 
however,  except  to  the  goldsmith  and  the  silversmith,  is 
nothing  more  than  a  medium  of  exchange.  The  olden- 
time  storekeeper  traded  commodity  for  commodity,  and 
even  in  comparatively  modern, times  many  transactions 
took  place  by  barter,  pure  and  simple.  The  cobbler  may 
trade  or  barter  five  pairs  of  shoes  for  one  overcoat,  or 
he  may  trade  five  pairs  of  shoes  for  $25.00  and  then  trade 
the  $25.00  for  the  overcoat.  The  use  of  a  medium  of 
exchange,  therefore,  is  a  matter  of  convenience.  The 
dollar  is  the  fiscal  yardstick  by  which  the  value  of  goods 
is  measured. 

Money  is,  in  itself,  nothing  more  than  a  universal  claim 
to  property — a  claim  not  against  one  person,  but  against 
all  the  civilized  world.  Accounting,  by  its  very  nature, 
must  employ  the  monetary  unit  in  recording  all  trans- 
actions. The  accountant  must  express  all  values  in  terms 

2  The  use  of  the  word  * '  person ' '  in  this  sense  refers,  not  only  to  an 
individual  human  being,  but  to  an  artificial  entity,  such  as  a  copartnership 
or  corporation. 


Assets  and  Their  Valuations  157 

of  such  a  unit.  This  is  so  obvious  as  to  require  no 
elaboration  and,  yet,  it  sets  the  stage  for  discussion  of 
some  of  the  most  difficult  problems  in  accounting  theory, 
viz.,  the  valuation  of  assets. 

PRIMARY  CLASSIFICATION  OF  ASSETS 

The  conventional  treatment  of  assets  is  to  classify  them 
first  as  positive  and  negative,  the  negative  asset  being 
a  liability,  but  the  accounting  problems  in  connection 
with  liabilities  are  comparatively  simple  and  will  not  be 
discussed  until  a  later  section. 

The  usual  and  most  convenient  classification  of  the 
positive  assets  is  the  one  normally  employed  by  the 
accountant  in  drawing  up  a  balance  sheet. 

Fixed  assets. 

Working  assets. 
Assets  -{ 

Current  assets. 

Deferred  assets. 

DEFINITIONS 

Very  roughly  these  four  classes  of  assets  may  be 
defined  as  follows : 

Fixed  assets  consist  of  tangible  or  intangible  proper- 
ties which  are  more  or  less  essential  to  the  continuation 
of  the  business  which  owns  them  and  which,  therefore, 
may  reasonably  be  expected  to  remain  in  the  possession 
of  that  business  for  an  indefinite  period.  It  is  usual  to 
classify  as  fixed  assets  such  items  as  "land,"  " build- 
ings, "  "machinery,"  "equipment,"  "franchises,"  and 
"goodwill." 

A  current  asset  is  one  which  is  readily  convertible 
into  cash  and  which,  by  its  nature,  probably  will  be 
converted  into  cash.  Such  assets  are  often  spoken  of  as 
being  liquid,  and  this  adjective  is  a  good  one,  since  it 


158  Principles  of  Accounting 

conveys  the  impression  of  a  ready  convertibility  and 
implies  "flowing, "  as  in  a  stream.  Examples  of  such 
assets  are  cash  itself,  certain  types  of  negotiable  instru- 
ments, such  as  bank  checks,  which  are  normally  regarded 
as  cash  by  the  average  business  man,  accounts  receivable, 
and  notes  receivable. 

Working  assets  usually  consist  of  supplies  and 
materials  of  various  sorts.  They  are  not  readily 
convertible  into  cash  without  some  loss  in  liquidation, 
but  in  a  going  business  they  ultimately  are  converted  into 
cash  through  the  ordinary  operations  of  manufacturing 
and  selling.  It  is  often  difficult  to  make  a  clean-cut  line 
of  demarcation  between  working  assets  and  current 
assets.  Some  working  assets  may  be  converted  into  cash 
before  certain  of  the  current  assets.  The  idea  back  of 
the  name  " working  assets"  is  that  they  are  "in  process" 
— that  something  remains  to  be  done  to  them  before  they 
can  be  properly  classified  as  "current."  Raw  materials, 
work  in  process,  and  supplies  of  various  sorts  are 
ordinarily  embraced  in  working  assets. 

Deferred  assets  have  been  rather  elaborately  treated 
in  the  preceding  chapter.  A  deferred  asset  represents 
an  expense  paid  in  advance.  Such  deferred  items  are 
properly  classed  as  assets,  because  they  serve  equally  as 
well  as  cash  itself  so  far  as  payment  for  the  expenses 
of  a  future  period  is  concerned. 

THE  ECONOMIC  CYCLE 

The  function  of  the  normal  business  is  that  of  adding 
utility  to  commodities.  These  are  economic  phrases, 
which  may  be  more  broadly  defined  as  follows :  ' '  Utility ' ' 
is  the  quality  of  being  desired  and  must  always  be 
sharply  distinguished  from  "usefulness."  Water  is 
useful,  but  has  no  utility.  Absinthe  is  not  useful,  but 


Assets  and  Their  Valuations  159 

has  utility.  Utility  in  a  commodity  may  usually  be 
obtained  by  effort  or  sacrifice.  In  a  natural  state,  water 
may  be  obtained  without  effort;  hence  it  has  no  utility 
and  cannot  be  bought  or  sold.  A  harmful  liquor,  on  the 
other  hand,  has  a  distinct  utility,  because  effort  must  be 
exerted  in  order  to  produce  or  obtain  it. 

The  function  of  business,  therefore,  is  that  of  adding 
utilities  to  commodities.  There  are  a  number  of  different 
kinds  of  utilities,  such  as  " place''  utility,  "time"  utility, 
and  "form"  utility.  The  railroad  adds  "place"  utility 
to  commodities.  A  cold  storage  company  adds  "time" 
utility  to  the  commodities  which  are  stored.  The  manu- 
facturer adds  "form"  utility  to  his  raw  materials. 

With  the  foregoing  in  mind,  it  is  easy  to  trace  the 
ordinary  business  cycle.  At  the  beginning  of  a  business, 
a  certain  amount  of  cash  may  be  provided  by  the  proprie- 
tor. A  portion  of  this  cash  is  invested  in  fixed  assets, 
a  portion  in  commodities  to  which  utility  is  to  be  added, 
and  the  balance  of  the  cash  is  expended  or  outlaid  in  the 
process  of  adding  utility  to  the  commodities,  this  being 
done  with  the  expectation  that  sales  at  an  advanced  price 
will  more  than  repay  all  such  outlays.  Eaw  material 
comes  into  the  business  and  is  a  working  asset.  It  is 
acted  upon  by  the  use  of  fixed  assets  such  as  machinery, 
and  by  labor  which  is  purchased  for  that  purpose.  It 
remains  a  working  asset  until  it  has  gone  through  the 
regular  routine  of  manufacture,  storage,  or  transporta- 
tion. Sales  are  then  made  of  this  finished  product  which, 
therefore,  disappears  as  an  asset,  and  in  its  place  appears 
a  current  asset,  such  as  an  account  receivable,  a  note 
receivable,  or  actual  cash.  These  current  assets  are 
again  utilized  for  the  purchase  of  more  raw  material,  for 
the  services  of  labor,  etc.,  and  this  cycle  repeats  itself 
all  during  the  life  of  the  business,  the  entire  basic  purpose 


160  Principles  of  Accounting 

• 

of  this  activity  being  the  'acquisition  of  profit.  Each 
time  the  cycle  is  made,  a  profit  should  normally  be  made, 
and  this  profit  consists  of  the  difference  between  the 
selling  price  and  the  amount  which  it  cost  to  purchase  the 
commodity  and  add  utility  to  it. 

It  may  clearly  be  seen  that  no  arbitrary  standards  of 
value  may  be  adopted  in  connection  with  assets.  What  is 
a  working  asset  today  may  be  a  current  asset  tomorrow, 
subject  to  transformation  into  a  deferred  asset,  or 
perchance  a  fixed  asset,  the  following  day.  It  is  neces- 
sary, however,  in  order  that  a  basis  may  be  afforded  for 
further  analysis  that  all  assets  be  classified  in  the 
manner  proposed.  At  any  given  instant  of  time  such 
a  classification  may  be  made  and,  since  the  balance  sheet 
is  a  picture  of  the  business  at  a  given  instant  of  time,  the 
items  on  the  balance  sheet  may  be  quite  accurately 
classified. 

PBIMAKY  BASIS  OF  VALUATION 

It  is  now  almost  uniformly  recognized  that  the  only 
proper  basis  of  valuation  of  an  asset  is  that  of  its  cost 
to  the  "going"  business.  The  value  at  which  it  appears 
on  the  balance  sheet  should  not  be  equivalent  to  the  price 
which  would  be  obtained  for  it  if  sold  "under  the 
hammer"  at  an  auction.  If,  for  balance  sheet  purposes, 
assets  were  valued  at  the  amount  they  would  bring  at  a 
forced  sale,  it  is  safe  to  say  that  no  business  could  claim 
to  be  solvent  on  the  basis  of  its  yearly  report.  In  every 
case  the  value  of  the  asset  must  be  viewed  from  the 
standpoint  of  the  "going"  business,  not  a  liquidating 
business. 

VALUATION  OF  CURRENT  ASSETS 

There  is  one  asset  which  is  automatically  self -valued. 
That  asset  is  money.  It  does  not  have  to  be  translated 


Assets  and  Their  Valuations  161 

into  terms  of  dollars  and  cents,  because  it  consists  of 
dollars  and  cents.  The  ordinary  business  man,  however, 
looks  upon  money  as  consisting,  not  only  of  gold  and 
silver,  but  of  certain  very  liquid  forms  of  claims,  i.  e., 
promises  to  pay  made  by  others  to  him.  First  and  fore- 
most are  various  kinds  of  paper  money  which,  in 
reality,  are  nothing  more  than  governmental  promises 
to  pay  upon  demand  a  given  amount  of  gold  or  silver. 
These  promises  may  be  direct  governmental  obligations 
or  indirect  as  in  the  case  of  national  bank  notes.  The 
note  issues  of  national  banks  are  secured  by  depositing 
United  States  bonds  with  the  government.  Under 
normal  economic  conditions,  with  a  stable  form  of  gov- 
ernment, such  promises  are  worth  their  face  value. 
There  is  no  question  as  to  valuation. 

Under  abnormal  economic  or  governmental  conditions, 
paper  money  may  be  worth  much  less  than  its  face 
value.  This  occurred  at  the  time  of  the  Civil  War  in 
the  case  of  the  Confederate  paper  money,  which  depre- 
ciated very  badly.  We  may,  however,  disregard  such 
abnormal  fluctuations  in  the  value  of  paper  currency  and 
for  balance  sheet  purposes  regard  it  as  being  equivalent 
to  gold  and  silver. 

Bank  checks  are  commonly  regarded  by  the  business 
man  as  the  equivalent  of  cash.  Checks  are  the  principal 
media  of  exchange  in  this  country.  Nearly  all  purchas- 
ing and  selling  is  done  by  the  use  of  checks.  A  "check" 
is  a  written  order  on  a  bank  by  a  depositor  to  pay  to 
another  person  a  certain  amount  in  cash.  The  use  of 
checks  is  so  prevalent  that  they  are  readily  accepted  in 
lieu  of  cash  where  the  maker  or  indorser  is  favorably 
known. 

Cash,  as  it  appears  on  the  balance  sheet,  does  not 
necessarily  refer  to  gold,  silver,  paper  money,  and  checks 


162  Principles  of  Accounting 

on  hand.  Cash  may  be  on  hand,  or  it  may  be  in  the 
bank.  Cash  in  the  bank  is  really  not  cash  at  all.  It 
is  an  account  receivable — a  claim  against  the  bank — but, 
as  a  matter  of  fact,  cash  at  the  bank  is  regarded  equal 
in  status  to  cash  on  hand.  Often  no  distinction  is  made 
between  the  two.  This  comes  about,  owing  to  the  con- 
fidence which  the  average  citizen  has  in  the  average 
bank.  Bank  deposits  are  usually  safeguarded  so  care- 
fully that  the  accountant  feels  justified  in  regarding  the 
bank  deposit  as  being  the  equivalent  of  cash  on  hand. 

DEBTS  RECEIVABLE 

Debts  receivable  form  a  somewhat  different  class  of 
asset.  The  value  of  cash  is  expressed  in  terms  of  itself. 
A  debt  receivable  is  expressed  in  terms,  not  of  itself,  but 
of  cash,  and  the  problem  is  at  once  presented  as  to  the 
valuation  of  such  assets.  Debts  receivable  really  include 
both  open  accounts  and  notes,  but  we  find  it  convenient  to 
confine  the  title  to  those  items  which  are  receivable  in  the 
immediate  future  and  which  are  unsecured  beyond  the 
implied,  verbal,  or  informal  promise  of  the  debtor  to  pay. 
The  time  of  payment  is  governed  by  the  terms  of  sale. 
Thus,  if  goods  are  sold  on  thirty  days'  time,  it  means 
that  the  purchaser  impliedly,  verbally,  or  informally 
contracts  to  pay  in  thirty  days.  This  promise  may  not 
be  evidenced  except  by  the  original  signed  purchase  order 
for  the  goods  and  subsequent  correspondence.  Further- 
more, such  a  promise  of  payment  is  not  always  strictly 
observed  as  to  amount  and  as  to  time.  A  debt  may  be 
due  for  payment  in  thirty  days,  but  any  man  who  was 
ever  engaged  in  business  knows  that  there  is  a  very 
strong  probability  that  many  of  his  debts  receivable  will 
not  be  paid  when  due.  Some  customers  will  take  sixty 
days,  others  ninety  days,  some  a  year  or  more,  and  some, 


Assets  and  Their  Valuations  163 

perhaps,  will  never  pay.  A  debt  receivable  is  a  legal  and 
enforceable  claim,  hence  it  is  considered  as  an  asset 
under  the  title  of  "Accounts  Receivable, "  but  credit  is 
granted  so  loosely  by  the  ordinary  business  man  that  it 
is  not  safe  to  take  all  these  "promises  to  pay"  at  their 
face  value. 

Insolvency  and  bankruptcy  are  common  in  this  country, 
which  simply  means  that  losses  on  accounts  receivable 
are  constant.  Knowing  that  such  losses  are  constant, 
the  business  man  may  make  provision  for  them.  His 
past  experience  shows  him  that,  on  the  average,  5% 
of  the  total  face  value  of  his  debts  receivable  will  prove 
worthless.  He,  thus,  has  an  adequate  basis  for  properly 
valuing  this  asset.  At  the  end  of  each  fiscal  period  he 
may  arbitrarily  reduce  the  value  of  this  asset  by  5%. 
This,  of  course,  implies  a  debit  to  the  account  usually 
called  "Bad  Debts "  and,  theoretically  at  least,  a  credit 
to  the  asset  account.  We  have  already  seen,  however, 
that  it  is  not  customary  to  credit  the  asset  account,  but 
rather  to  credit  another  account,  which  is  technically 
known  as  a  "valuation  account. "  The  effect  of  such  a 
valuation  account  is  that  of  subtraction.  It  simply 
represents  the  credit  side  of  the  asset  account,  and 
includes  only  those  deductions  from  the  value  of  the 
asset  account  which  have  been  charged  to  proprietorship. 
For  example,  if  accounts  receivable  stood  on  the  books 
at  $100,000.00,  either  of  the  following  two  entries  would 
be  correct  in  case  it  was  desired  to  charge  off  5%. 

Bad  Debts  (an  expense  account) $5,000.00 

Accounts  Eeceivable  (an  asset  account) $5,000.00 

or 

Bad  Debts  (an  expense  account) $5,000.00 

Allowance  for  Bad  Debts  (a  valuation  account) $5,000.00 


164  Principles  of  Accounting 

After  the  first  entry  was  posted  the  Accounts  Receiv- 
able  Account  would  show  a  debit  of  $100,000.00  and  a 
credit  of  $5,000.00.  This  would  .  leave  a  balance  of 
$95,000.00  as  representing  the  value  of  accounts  receiv- 
able. If  the  second  entry  were  made  instead  of  the 
first,  the  Accounts  Receivable  Account  would  show  on 
the  debit  side  $100,000.00  and  on  the  credit  side  nothing 
at  all,  but  there  would  have  been  set  up  a  valuation 
account  with  a  credit  for  $5,000.00.  To  arrive  at  the 
actual  value  of  accounts  receivable,  it  would  be  necessary 
to  make  a  combination  of  the  two  accounts,  viz.,  the 
Accounts  Receivable  Account  and  Allowance  for  Bad 
Debts.  The  net  result  of  these  two  taken  into  combina- 
tion would  be  $95,000.00. 

It  is  important  to  bear  in  mind  that  a  valuation  account 
is  not  a  liability,  nor  is  it  a  proprietary  account.  It  is 
an  account  set  up  for  valuation  purposes,  which  does 
nothing  more  than  register  the  deduction  which  may 
have  to  be  made  from  the  corresponding  asset  account. 
It  is  always  wrong,  for  balance  sheet  purposes,  to  show 
the  balance  of  such  a  valuation  account  on  the  liability 
side.  Such  a  balance  should  be  deducted  from  the  asset 
account  in  an  interior  column  of  the  balance  sheet  and 
extended  into  the  regular  column  at  the  net  figure. 

Debts  receivable  are  always  booked  at  their  face  value. 
In  addition  to  the  fact  that  the  face  value  does  not  tell 
the  truth,  owing  to  possible  losses  by  bad  debts,  it  also 
is  inaccurate  because  payment  of  the  account  in  cash  is 
deferred  until  some  future  time.  Everyone  is  familiar 
with  the  force  called  "interest,"  and  everyone  knows  that 
a  present  dollar  is  worth  more  than  a  future  dollar.  If  an 
interest  rate  of  6%  is  assumed,  a  present  dollar  is  worth 
$1.00,  but  a  claim  for  $1.00,  payable  a  year  from  the 
present  time,  is  worth  approximately  only  94  cents.  It 


Assets  and  Their  Valuations  165 

is,  therefore,  clear  that  all  accounts  receivable  are  worth 
less  than  their  face  value,  but  inasmuch  as  the  time  of 
payment  is  not  definitely  known,  it  would  prove  an 
impossible  task  to  obtain  the  present  value  of  such  a 
future  promise  to  pay.  It  is,  therefore,  an  inaccurate, 
but  common  and  entirely  justifiable,  custom  to  ignore  this 
slight  difference  existing  between  the  face  value  of  such 
a  claim  and  its  discounted  value. 

NOTES  RECEIVABLE 

Notes  receivable  differ  from  accounts  receivable  in  that 
they  are  formal  written  promises  instead  of  implied 
verbal  or  informal  promises  to  pay.  A  note  receivable 
contains  a  definite  promise  in  written  form  and  is  fre- 
quently negotiable.  It  specifies  the  date  of  payment  and 
the  place  of  payment,  and  lawsuit  can  be  brought  on  the 
note  itself  as  prima  facie  evidence  of  debt,  wherein  it 
differs  from  an  account  receivable.  An  action  at  law  to 
enforce  payment  of  an  account  receivable  item  requires 
the  production  of  evidence  that  a  service  has  been  actually 
performed  or  value  given.  A  note  receivable  imports 
consideration,  that  is,  that  value  has  been  given  and, 
except  under  special  conditions,  requires  no  collateral 
evidence.  The  Statute  of  Limitations  in  the  several 
states  may  be  different  for  notes  and  accounts. 

A  note  receivable  may  or  may  not  be  paid,  just  as  in 
the  case  of  any  debt,  but  it  is  usually  unnecessary  to  make 
as  large  a  provision  for  uncollectible  notes  as  it  is  for 
ordinary  debts.  This  is  because  a  man  very  often  will 
buy  a  bill  of  goods  without  knowing  exactly  how  he  is 
going  to  get  the  money  to  pay  for  them,  but  that  same 
man  will  usually  be  much  more  careful  about  signing 
a  note,  since  it  is  a  formal  instrument,  and  he  is  far  more 
likely  to  make  provision  for  paying  it  at  the  due  date. 


166  Principles  of  Accounting 

In  the  case  of  ordinary  debts  receivable  it  was  observed 
that  no  accurate  determination  could  be  made  of  their 
discounted  value,  that  is,  the  difference  between  their 
value  now  and  their  face  value.  This  was  found  to  be 
true  because  the  due  date  was  not  definitely  known.  In 
the  case  of  a  note,  however,  the  due  date  is  specifically  a 
part  of  the  note  itself,  and  by  use  of  mathematical  pro- 
cesses or  formulae  it  is  possible  to  make  an  accurate 
determination  of  the  present  value  of  notes  receivable, 
always  assuming  they  will  be  paid  when  due.  Thus,  the 
present  value  of  a  non-interest  bearing  note  for  $103.00, 
payable  in  six  months,  is  exactly  $100.00,  if  the  current 
rate  of  interest  is  6%.  The  rule  which  is  used  in  deter- 
mining the  present  value  is  as  follows: 

To  find  the  present  worth  of  an  amount  due  at  a  future  date, 
divide  the  amount  by  the  amount  of  $1.00  placed  at  interest  for 
the  given  time.  For  example,  a  non-interest  bearing  note  for 
$1,000.00  due  in  two  years  has  a  present  value  of  approximately 
$890.00,  if  the  current  and  accepted  rate  of  interest  be  5%. 
The  formula  for  obtaining  this  figure  is  as  follows : 

Amount  due   in  two  years       $1,000.00 

= =  $890  Approximate  present  worth 

Value  of  $1.00  in  two  years 

at  compound    5%    interest         $1.1236 

Theoretically,  such  a  determination  of  present  worth 
of  all  notes  receivable  should  be  made  at  the  end  of  every 
accounting  period.  This,  however,  is  often  omitted,  since 
the  amounts  involved  may  not  be  large.  For  practical 
purposes  it  is  more  convenient  to  omit  the  detailed 
calculation  on  each  note.  Where  the  notes  receivable  are 
for  large  amounts  and  where  they  run  for  a  considerable 
period,  such  a  determination  should  be  made.3 

3  Where  a  note  receivable  is  interest  bearing,  it  is  obvious  that  the 
present  worth  is  equal  to  the  face  value.  It  is  only  in  the  case  of  non-interest 
bearing  notes  that  this  calculation  would  ever  have  to  be  made. 


Assets  and  Their  Valuations  167 

BILLS  RECEIVABLE 

Bills  receivable  are  unconditional  written  orders  by 
one  person  upon  another  (or  by  us  upon  a  debtor)  to  pay 
us  a  sura  of  money  named.  They  are  negotiable  instru- 
ments of  exchange  which  must  be  "  accepted "  by  the 
debtor  before  being  set  up  on  our  books  as  an  asset.  The 
time  of  payment  is  "on  demand "  or  at  a  fixed  future 
date. 

Until  "  accepted "  such  orders  have  no  standing  so  far 
as  the  books  of  account  are  concerned.  After  being 
accepted  they  may  be  set  up  as  assets.  Accepted  bills, 
or  acceptances,  as  they  are  called,  are  considered  the 
equivalent  of  notes  and  are  governed  by  the  same  general 
principles  of  valuation. 

MERCHANDISE  OR  FINISHED  GOODS  ACCOUNT 

There  is  still  another  kind  of  current  asset  which  might 
be  considered.  Various  names  are  applied  to  the  account 
which  represents  this  asset.  It  is  frequently  spoken  of 
as  the  Merchandise  Account  or  the  Finished  Goods 
Account,  and  it  represents  commodities  which  are  on 
hand  ready  for  sale.  Although  a  discussion  of  the 
problems  incident  to  the  valuation  of  this  asset  properly 
belongs  here,  it  is  deemed  better  to  consider  them  later 
in  connection  with  the  valuation  of  working  assets. 

WORKING  ASSETS 

The  items  that  appear  on  a  balance  sheet  under  the 
classification  of  "working  assets"  consist  of  inventories 
of  raw  material,  supplies,  and  partly  finished  goods.  The 
generally  accepted  policy  with  regard  to  the  valuation  of 
such  items  is  that  they  shall  be  carried  at  cost  price  and, 
furthermore,  that  this  cost  price  shall  represent,  not  only 


168  Principles  of  Accounting 

the  bare  material  cost,  but  all  other  costs  which  have  been 
incurred  in 

1.  Getting  the  material  to  the  factory. 

2.  Labor  in  unpacking  and  uncrating  material. 

3.  Labor  and  overhead  expense  directly  assignable 

to  partly  finished  goods. 

It  must  be  further  recognized  in  valuing  such  assets 
that  the  basis  of  valuation  is  not  the  liquidation  value  but 
that  to  a  going  concern. 

FLUCTUATING  VALUES 

. 

It  sometimes  happens  in  the  case  of  raw  material  that 
the  market  price  fluctuates  so  greatly,  owing  to  speculative 
conditions  of  the  commodity  markets,  that  the  original  cost 
price  will  sometimes  be  greater  than  the  current  market 
quotations.  For  example,  copper  might  be  purchased 
at  16  cents  a  pound  and  within  a  few  weeks  the  market 
for  copper  might  slump  down  to  11  cents  a  pound.  From 
the  standpoint  of  pure  theory,  this  should  not  affect  the 
price  at  which  the  copper  would  be  carried  on  the  books, 
but  from  a  practical  standpoint,  it  is  deemed  wiser  to 
inventory  the  copper  at  the  lower  of  the  two  prices.  It  is 
practically  an  unwritten  law 4  among  accountants,  in  the 
case  of  the  valuation  of  merchandise,  that  the  cost  price 
must  be  used  as  the  basis,  unless  the  market  price  hap- 
pens to  be  lower.  This  appears  to  be  a  somewhat  unfair 
and  unreasonably  conservative  doctrine.  It  means  that 
a  company  must  value  each  asset  at  the  lowest  possible 
figure — that  it  must  recognize  fluctuations  when  they  are 

*  It  should  be  noted  that  many  cost  accountants  quarrel  with  this  doc- 
trine, insisting  that  material  should  be  shown  on  the  books  at  cost,  regardless 
of  fluctuations. 


Assets  and  Their  Valuations  169 

unfavorable  in  their  nature,  but  that  it  may  take  no 
account  of  any  favorable  fluctuations. 

It  is  conceded  by  accountants  to  be  a  dangerous  thing 
to  take  appreciation  into  consideration.  The  accountant 
argues  that  human  beings  are  too  optimistic  any  way— 
that  they  will,  out  of  sheer  hopefulness,  overvalue  their 
holdings  if  given  a  chance.  Experience  certainly  proves 
that  it  is  much  wiser  to  be  ultra-conservative  with  respect 
to  balance  sheet  valuations,  particularly  in  so  far  as  the 
working  assets  are  concerned. 

ELEMENTS  OF  BOOK  COST 

Incoming  freights,  incoming  express,  and  incoming 
drayage  costs  are  all  proper  additions  to  the  cost  of 
merchandise,  since  it  is  clear  that  their  cost  to  the  pur- 
chaser is  not  the  f .  o.  b.  cost,  but  rather  the  cost  laid  down 
in  his  own  warehouse. 

Materials  and  merchandise  are  often  quoted  for  sak 
at  a  list  price  subject  to  a  trade  discount.  These  trade 
discounts  are  often  large  in  amount,  sometimes  as  much 
as  50%.  Such  trade  discounts  must  always  be  deducted 
from  the  value  of  merchandise  purchased.  If  a  certain 
material  was  listed  at  $20.00,  subject  to  a  25%  trade  dis- 
count, the  proper  charge  to  the  Material  Account  would 
be  $15.00  and  not  $20.00.  Trade  discounts  amount  simply 
to  reductions  in  price. 

There  is  considerable  diversity  of  opinion  among  ac- 
countants as  to  the  treatment  of  cash  discounts  on  pur- 
chases. Should  such  discounts  be  considered  as  deduc- 
tions from  the  cost  of  material  purchased!  This  ques- 
tion can  be  answered  with  a  "yes"  or  "no,"  depending 
upon  the  viewpoint.  It  is  certainly  true  that  if  the 
amount  of  the  discount  is  not  deducted  from  the  cost  of 
the  goods  that  an  anomalous  situation  results. 


170  Principles  of  Accounting 

Suppose  $20.00  worth  of  merchandise  is  purchased  and 
a  cash  discount  of  2%  is  taken.  If  this  cash  discount  is 
not  considered  a  reduction  in  the  cost  price,  the  books 
will  show  that  $19.60  in  cash  was  paid  out  for  certain 
goods  which  were  charged  in  to  the  Material  Account  at 
$20.00.  It  would  seem,  however,  that  the  accountants 
who  support  such  procedure  have  the  best  of  the  argu- 
ment. They  claim  that  cash  discounts,  given  or  taken, 
are  financial  in  their  nature  and  that  they  measure  the 
adequacy  or  inadequacy  of  the  capital  invested  in  the 
business.  If  a  company  has  capital  enough  to  take  ad- 
vantage of  purchase  discounts,  the  credit  is  due  to  the 
sufficiency  of  capital,  which  makes  such  savings  possible. 
The  company  which  has  insufficient  capital  cannot  take 
advantage  of  such  opportunities.  A  cash  discount  may 
be  taken  by  that  concern  which  is  financially  able,  but  the 
sufficiency  or  insufficiency  of  cash  should  not  be  allowed 
to  affect  the  value  of  merchandise.  If  such  a  cash  dis- 
count is  considered  a  deduction  in  price,  then  the  concern 
which  had  sufficient  capital  to  take  a  discount  of  40  cents 
on  a  $20.00  invoice,  would  be  penalized  by  being  forced 
to  value  the  purchase  at  only  $19.60,  while  the  other  con- 
cern with  insufficient  capital  would,  because  of  its  sheer 
inability  to  take  the  discount,  be  privileged  to  value  the 
same  merchandise  at  $20.00. 

MATERIALS  IN  PROCESS 

The  problems  entering  into  the  valuation  of  materials 
in  process  are  peculiarly  those  of  the  cost  accountant. 
The  same  general  rules,  however,  apply  to  their  valuation 
as  in  the  case  of  raw  material  and  supplies.  Cost  price 
only  must  be  used,  the  one  exception  to  this  rule  being  in 
the  case  of  a  business  which  handles  long-time  contracts. 
It  is  then  sometimes  allowable  for  a  certain  proportion 


Assets  and  Their  Valuations  171 

of  the  estimated  profit  to  be  taken  into  the  accounts  each 
period.  Conservative  auditors  always  view  such  a  pro- 
cedure with  a  suspicious  eye,  however,  and  are  prone  to 
guard  carefully  against  the  danger  of  "anticipating 
pro  fits. " 

Suppose,  for  example,  that  a  contractor  had  a  $100r 
000.00  contract,  which  would  require  three  years  for  com* 
pletion.  It  would  seem  unreasonable  and  unfair  to  insist 
that  for  the  first  two  years  he  should  show  no  profits  at 
all  and  for  the  last  year  a  very  large  profit.  In  such  a 
case,  which  would  occui*  but  rarely,  the  accountant  feels 
justified  in  permitting  the  contractor  to  take  credit  for  a 
reasonable  proportion  of  the  profits  each  year  and  at  the 
same  time  carefully  safeguards  him  by  establishing 
ample  reserves  for  contingencies. 

MATERIAL  AND  SUPPLY  ACCOUNTS 

There  are  two  general  ways  of  handling  material  and 
supply  accounts :  The  first  method  is  to  charge  all  incom- 
ing material  to  a  purchases  account.  To  determine  the 
amount  used  and  the  balance  on  hand  under  this  system, 
it  is  necessary  to  take  a  physical  inventory.  The  taking 
of  such  an  inventory  is  a  laborious  task ;  hence  this  system 
is  not  ordinarily  employed  where  there  is  a  shorter 
accounting  period  than  one  year.  The  second  method 
of  handling  such  accounts  is  to  charge  all  incoming  mate- 
rials and  supplies  to  material  and  supply  accounts  and 
to  credit  those  accounts,  at  cost,  whenever  materials  and 
supplies  are  withdrawn  for  use.  Such  a  procedure  as 
this  contemplates  a  modern  system  of  keeping  stores  with 
some  responsible  person  in  charge  of  the  stores.  This 
individual,  who  is  usually  known  as  the  "  storekeeper, "  is 
held  strictly  responsible  for  the  supplies  and  material  in 
his  care.  He  is  required  to  give  a  receipt  for  all  incoming 


172  Principles  of  Accounting 

material  and  supplies  and  to  take  a  receipt  for  all  mate- 
rial or  supplies  which  he  relinquishes. 

By  operating  under  such  a  system  as  this,  it  is  compara- 
tively easy  for  the  storekeeper  to  keep  what  is  known  as 
a  ' '  perpetual  inventory  system ' '  or  a  l '  Store 's  Ledger. ' ' 
In  its  simple  form  a  Store's  Ledger  may  be  very  much 
like  an  ordinary  ledger.  One  sheet  in  this  ledger  is 
assigned  to  each  kind  or  class  of  stores.  Whenever  mate- 
rial is  received,  it  is  debited  to  the  proper  account  in  the 
Store 's  Ledger.  Whenever  a  quantity  of  the  same  mate- 
rial is  issued,  it  is  credited  to  the  Store's  Ledger  Account. 
The  balance  of  that  account,  therefore,  should  always 
coincide  with  the  amount  of  material  actually  left  on 
hand  for  which  the  storekeeper  is  responsible.  In  a  large 
storeroom  of  a  manufacturing  plant  there  may  be  thou- 
sands of  kinds  of  materials  and  supplies  with  an  account 
for  each  size  or  grade  of  each  kind.  The  Store's  Ledger 
is  a  subsidiary  ledger  and  is  represented  in  the  General 
Ledger  by  a  controlling  account  called  "Materials 
Account."  (Instead  of  one  control  account  there  may  be 
several  classified  control  accounts.) 

ACCOUNTING  FOE  MATERIALS 

One  common  method  of  accounting  for  materials  may 
be  outlined  as  follows:  Each  stock  ledger  account 
(Figure  49)  should  indicate  the  maximum  and  minimum 
quantity  which  it  is  desirable  to  keep  in  stock.  When  the 
supply  of  any  article  runs  below  the  minimum,  the  store- 
keeper should 

1.  Notify  the  proper  department  head  of  the  shortage. 

2.  Take  a  physical  inventory  of  the  goods. 

3.  Reconcile  the  stock  ledger  account  balance  with  the 

true  balance. 

4.  Send  an  overage  or  shortage  report  to  the  auditor. 


Assets  and  Their  Valuations 


173 


FiQ.  49. — Common  Forms  of  Stock  Ledger  Accounts 


174 


Principles  of  Accounting 


REC/ 

FR< 

kPITULATIOfN 

DM                        n 

1     C 

EFT 
H  0 

)F    REQUISITIONS 

.  TO  STORES    DERT. 
F                               181 

DURING    MONTI 

REQUISITIONS 

CREDITS  TO  STORES  ACCOUNTS 

DAY 

NUMBER 

SUPfllES 

RAW  MAT1 

No.  1 

RAW  MAFL 
No.  2 

RAW  MAT'L 
No.  3 

FINISHED 
GOODS 

PARTS 

MISC. 

N 

I  '  —  ' 

->  ' 

DATE. 


.191 


SlGNEO. 


STOREKEEPER 


FIG.  50. — Eecapitulation  of  Eequisitions 


Assets  and  Their  Valuations  175 

When  the  department  head  receives  the  notification,  he 
may  make  a  requisition  upon  the  purchasing  agent,  who 
will  order  a  new  supply.  This  purchase  order  may  be 
made  up  with  one  original  and  four  carbons,  disposable 
as  follows : 

1.  Mailed  to  the  supplying  company. 

2.  Filed  in  the  "Unfilled  Orders  File." 

3.  Filed  in  the  office  file. 

4.  Sent  to  receiving  clerk. 

5.  Sent  to  receiving  clerk. 

Copies  4  and  5  are  made  with  short  carbons.  They 
may  show  the  price  but  not  the  quantities. 

When  the  goods  are  received,  they  are  checked  against 
these  carbons  and  the  receiving  clerk's  count  or  weight 
is  inserted.  One  of  the  carbons  then  goes  to  the  auditor, 
where  it  is  attached  to  the  proper  voucher  jacket.  The 
other  one  forms  the  basis  of  the  storekeeper's  charges  to 
the  stock  ledger  accounts. 

When  materials  or  supplies  are  needed  in  the  shop,  they 
are  requisitioned  from  the  storekeeper.  The  storekeeper 
should  never  release  materials  to  the  shop  except  upon 
requisition,  the  latter  being  his  receipt  for  the  goods. 
From  the  requisitions,  the  storekeeper  makes  his  credits 
to  the  stock  ledger  accounts.  At  the  end  of  each  month 
a  Recapitulation  of  Requisitions  (Figure  50)  is  made  up 
and  sent  to  the  Cost  Department.  From  this  the  General 
Ledger  control  accounts  receive  credits  for  the  total 
requisitions. 

CONTROLLING  ACCOUNTS 
Charges  Credits 

From  Voucher  Register  From  Requisition  Recapitulation 


176  Principles  of  Accounting 

STOCK  LEDGER 

Charges  Credits 

From  copy  of  original  purchase  or-      From  original  requisitions 
der,  which  has  been  " checked"  by 
receiving  clerk 

The  general  ledger  entries  are  made  monthly  in  lump 
sums. 

Materials  Account  8   $ 

Vouchers  Payable  $ 

For    the   monthly   total    of    vouehered   material 

purchases 
Work  in  Process 

Materials  Account 5    

For   the   total   material   requisitioned   from   the 

storeroom  during  the  month 

The  method  of  handling  discrepancies  between  book 
and  actual  inventories  is  for  the  storekeeper  to  adjust  his 
book  inventories  to  bring  them  into  accord  with  the  facts, 
reporting  the  overages  and  shortages  to  the  auditor.  The 
latter  then  makes  the  following  general  ledger  entry  for 
each  shortage: 

Over  and  Short  Account $ 

Materials  Account $ 

A  reverse  entry  is  made  for  overages  which  will  be 
infrequent.  The  Over  and  Short  Account  should  not  be 
absorbed  into  "Operation,"  but  should  remain  on  the 
books  as  an  index  of  the  storekeeper's  efficiency. 

When  the  balance  reaches  a  certain  fixed  account,  the 
storekeeper  should  be  called  upon  for  explanation  or,  per- 
haps, discharged.  It  is  well  to  keep  the  existence  of  this 
Over  and  Short  Account  a  secret  from  the  storekeeper 
since,  otherwise,  he  might  be  tempted  to  falsify  his  re- 
ports. It  is  also  a  good  idea  for  periodical  "surprise" 

•  These  entries  are  only  suggestive.  As  a  matter  of  fact,  there  would  prob- 
ably be  a  number  of  classified  material  control  accounts  in  the  General  Ledger. 


Assets  and  Their  Valuations  177 

inventories  to  be  made  of  selected  classes  of  stores  for 
the  purpose  of  checking  the  storekeeper's  reports. 

A  detailed  description  of  the  methods  used  in  handling 
materials  and  supplies  more  properly  belongs  to  a  treatise 
on  factory  accounting  than  to  the  present  work,  but  a 
general  description  of  it  at  this  point  seems  necessary 
because  of  the  problem  which  comes  up  in  connection 
with  the  valuation  of  working  assets  under  any  perpetual 
inventory  scheme.  The  cost  price  must  be  used,  but  this 
must  be  an  averaged  cost  price.  For  instance,  suppose 
that  1,000  pounds  of  copper  were  purchased  for  11  cents 
a  pound  f.  o.  b.  destination  and  that  600  pounds  of  that 
copper  were  used.  The  entry  in  the  Copper  Account  in 
the  subsidiary  store  ledger  would  consist  of  a  debit  of 
$110.00  (representing  1,000  pounds  of  copper  at  11  cents 
a  pound)  and  a  credit  of  $66.00  (representing  600  pounds 
of  copper  at  11  cents  a  pound).  The  balance  of  copper 
on  hand  according  to  that  material  account  would  then 
be  1,000  pounds  minus  600  pounds,  or  400  pounds.  The 
value  of  the  copper  left  on  hand  would  be  $110.00  minus 
$66.00,  or  $44.00.  Suppose  that  100  pounds  of  copper 
were  now  purchased  at  16  cents  a  pound.  What  would  be 
the  value  of  the  copper  on  hand?  The  value  would  ob- 
viously be  the  sum  of  400  pounds  at  a  cost  of  $44.00  and 
100  pounds  at  a  cost  of  $16.00,  or  500  pounds  costing 
$60.00 — a  ' '  unit  price ' '  of  exactly  12  cents  a  pound.  This 
is  the  price  which  should  be  used  in  recording  the  issu- 
ance of  further  copper.  In  determining  this  price  of  12 
cents  a  pound  it  will  be  noted  that  a  weighted  average 
was  taken  and  not  a  straight  average.  Taking  the 
straight  average  would  result  in  a  unit  price  of  13% 
cents,  but  it  is  clear  that  this  figure  would  be  incorrect. 

When  we  speak  of  the  necessity  of  using  cost  prices  in 
valuing  working  assets,  we  mean  that  actual  cost  prices 


178  Principles  of  Accounting 

must  be  used.  Unless  this  is  done,  serious  misrepresen- 
tation will  result.  Two  policies  should  be  strictly 
avoided : 

1.  All  the  material  and  supplies  should  not  be  valued 
at  the  cost  price  of  the  last  lot  purchased.     This  is  impor- 
tant since  otherwise  a  dishonest  or  unwise  manager  might 
purchase  40,000  pounds  of  copper  at  10  cents  a  pound 
and  later  purchase  100  pounds  at  20  cents  a  pound.     If 
he  were  allowed  to  value  all  the  copper  on  hand  at  the 
cost  of  the  last  consignment,  the  result  would  be  a  gross 
inflation  of  the  inventory  and,  consequently,  a  better  bal- 
ance sheet  showing.     In  the  particular  illustration  used, 
the  misrepresentation  would  amount  to  $4,000.00. 

2.  Prices   should  not  be   averaged   according  to  the 
method  of  straight  averages  instead  of  weighted  aver- 
ages.    The  average  unit  cost  of  40,000  pounds  of  copper 
at  10  cents  and  100  pounds  of  copper  at  20  cents  is  not 
15  cents,  but  only  a  very  small  fraction  over  10  cents. 

Precisely  the  same  principles  which  apply  to  the  valua- 
tion of  working  assets  also  strictly  apply  to  the  valuation 
of  finished  goods,  although  finished  goods  may  be  classi- 
fied as  a  current  asset. 

FIXED  ASSETS 

Fixed  assets  may  be  roughly  classified  into  tangible 
and  intangible.  Tangible  fixed  assets  include  such 
items  as 

1.  Land. 

2.  Buildings. 

3.  Machinery,  Furniture  and  Fixtures. 

4.  Investments, 


Assets  and  Their  Valuations  179 

Intangible  fixed  assets  include 

1.  Goodwill. 

2.  Franchises. 

3.  Patents. 

The  general  principle  underlying  the  valuation  of  fixed 
assets  is  that  they  shall  be  carried  at  cost  regardless  of 
current  fluctuations  in  value,  but  that- accounting  devices 
to  measure  lessening  value  must  be  taken  into  considera- 
tion. There  is  always  some  justification  for  arguments 
that  favor  a  recognition  of  the  market  price  in  the  case 
of  working  assets,  but  no  sound  arguments  can  be  brought 
forward  in  justification  of  a  similar  treatment  of  fixed 
assets.  The  reason  for  this  is  clear.  Working  assets 
consist  either  of  materials  or  of  supplies.  The  materials 
are  intended  for  ultimate  resale  in  some  altered  form, 
while  the  supplies  are  consumed  in  making  the  materials 
marketable.  Both  materials  and  supplies,  therefore,  are 
transitory  and  are  either  directly  or  indirectly  intended 
for  resale.  The  state  of  the  commodity  markets  has  a 
direct  effect  upon  the  prices  which  will  be  ultimately  real- 
ized for  the  finished  goods  and  the  merchandise  into  which 
the  working  assets  are  to  be  transformed.  Hence  there 
is  a  logical  justification  for  a  partial  recognition  of  com- 
modity market  fluctuations. 

The  status  of  fixed  assets  is  entirely  different.  A  fixed 
asset  is  a  permanent  holding  and  ordinarily  may  not  be 
parted  with  until  dissolution  of  the  business.  Fixed 
assets  are  essential  to  and  inseparable  from  the  business 
which  owns  them.  Since  they  are  not  intended  for  resale, 
market  fluctuations  in  their  value  will  have  no  effect  upon 
the  current  profits  of  the  business. 

There  is  a  corollary  to  the  foregoing.  Market  fluctua- 
tions may  be  ignored,  but  it  is  of  prime  importance  that 


180  Principles  of  Accounting 

some  well-considered  plans  of  depreciation  and  amortiza- 
tion 6  be  followed.  Certain  classes  of  fixed  assets  depre- 
ciate more  than  others.  This,  however,  does  not  affect 
the  rule  as  above  laid  down.  It  only  affects  the  rate. 

Sometimes  a  peculiar  situation  results  from  a  rigid 
adoption  of  these  two  policies.  For  example,  let  us  con- 
sider the  case  of  an  industry  purchasing  real  estate  on 
the  outskirts  of  a  city,  and  building  thereon  a  factory. 
The  total  investment  in  land  might  be  $10,000.00  and  in 
buildings  $20,000.00.  If  they  followed  a  conservative 
practice  such  as  has  been  outlined,  they  would  charge  off 
each  year  a  certain  percentage  of  their  Buildings  Account 
to  Depreciation  (note  that  land,  in  and  of  itself,  is  not 
usually  subject  to  depreciation,  although  it  may  be  under 
certain  circumstances).  In  twenty  years  they  may  have 
charged  off  the  entire  $20,000.00  represented  by  their 
Buildings  Account,  and  the  books  would  then  show  real 
estate  valued  at  $10,000.00  and  buildings  valued  at  noth- 
ing. Owing  to  the  growth  of  the  city  during  the  twenty- 
year  period,  the  management  might  decide  to  sell  its 
property  and  move  elsewhere.  It  is  far  from  inconceiv- 
able that,  in  such  a  period  of  time  and  under  favorable 

e  The  following  definition  is  the  one  proposed  by  the  Committee  on 
Accounting  Terminology  of  the  American  Association  of  Public  Accountants 
under  date  of  August  31,  1915. 

Amortization — The  gradual  extinguishment  of  the  amount  of  an  asset, 
liability,  profit,  or  loss  by  prorating  it  over  the  period,  during  which  it  will 
exist  or  during  which  its  benefit  will  be  realized.  Specifically, 

1.  The  gradual  extinction  of  a  debt  as,  for  instance,  by  means  of  a 
sinking  fund. 

2.  The  gradual  reduction  in  the  valuation  of  an  asset,  thus  anticipating 
the  time  when  it  shall  eventually  become  worthless;  as  distinguished  from 
provision  for  depreciation  or  replacements. 

3.  The  absorption  in  the  income  or  profit  and  loss  accounts  during  the 
pending  of  the  debt,  of  a  discount  incurred  or  of  a  premium  realized  in  the 
sale  of  an  obligation,  which  discount  or  premium  may  be  carried  in  the 
meantime,  in  a  debit  or  in  a  credit  suspense  account, 


Assets  and  Their  Valuations  181 

circumstances,  real  estate  values  might  have  increased 
several  hundred  per  cent  and  that  the  land  which  they 
bought  for  $10,000.00  might  be  sold  for  $75,000.00. 

Sales  price  of  land $75,000.00 

Original  cost  of  land 10,000.00 


Profit  on  sale  of  land $65,000.00 

It  would  clearly  be  improper  to  treat  this  $65,000.00  as 
a  profit  of  the  last  accounting  period.  What  it  really  is, 
is  the  accumulation  of  twenty  years'  profits,  due  to  a 
regular  appreciation  in  value  of  the  land.  This  figure 
of  $65,000.00  must  be  credited  not  to  Profit  and  Loss  of 
the  current  period,  but  direct  to  some  capital  account 
such  as  Capital  Surplus.  Accountants  realize  that  such 
occurrences  are  not  improbable,  but  they  deem  it  more 
conservative  to  ignore  the  gradual  appreciation  in  value 
of  real  estate  and  to  take  no  credit  for  such  gains  until 
the  profit  is  actually  realized.  It  is  then  creditable 
directly  to  a  capital  account  instead  of  one  of  the  current 
income  accounts. 

Managers  and  owners  often  protest  bitterly  when  told 
that  they  must  make  provision  for  depreciation  of  the 
fixed  assets,  but  they  are  not  allowed  to  offset  this  by  an 
increased  value  of  land.  If  a  building  is  depreciating  at 
a  rate  of  $2,000.00  a  year  and  land  is  appreciating  at  a 
rate  of  $3,000.00  a  year,  it  seems  reasonable  to  the  owner 
or  manager  to  consider  that  a  $1,000.00  gain  has  been 
made. 

There  appears  to  be  some  justice  in  the  claim  that  an 
unfair 'showing  of  profit  and  loss  is  made  when  current 
depreciation  is  required  and  current  appreciation  is  ig- 
nored. The  rule  is,  however,  a  very  sound  one.  To  a 
going  concern,  rapidly  appreciating  real  estate  has  no 


182  Principles  of  Accounting 

more  value  than  when  it  was  first  purchased,  and  on  the 
principle  of  regarding  assets  from  the  viewpoint  of  the 
going  business,  real  estate  and  similar  assets  must  plainly 
be  valued  at  cost. 

As  a  further  justification  for  the  conservative  prac- 
tices recommended  in  connection  with  the  valuation  of 
fixed  assets,  it  should  be  noted  that  it  is  very  difficult  to 
appraise  real  estate  properly.  To  make  such  an  apprai- 
sal every  year  for  the  purpose  of  taking  credit  for  antici- 
pated profits  due  to  appreciation  of  the  land  would  lead 
to  inaccuracy,  particularly  if  different  appraisers  were 
employed  each  year,  since  the  judgment  of  one  real  estate 
expert  might  be  widely  different  from  that  of  another. 

Fixed  tangible  assets,  other  than  real  estate,  should  be 
subject  to  a  well-considered  depreciation  policy. 

As  indicated  in  the  case  of  other  classes  of  assets,  fixed 
assets,  both  tangible  and  intangible,  should  be  booked  at 
cost  price — the  cost  to  the  "going"  concern. 

In  the  light  of  the  foregoing  principles  we  may  now 
consider  the  case  of  particular  kinds  of  assets. 

LAND 

Land  should  be  valued  at  the  cost  of  acquisition.  This 
may  not  necessarily  be  equal  to  the  purchase  price. 
Grading,  street  improvements,  etc.,  may  be  necessary  be- 
fore the  land  is  ready  for  use,  and  such  items  may  be 
included  in  the  book  cost  of  the  land.  Broadly  speaking, 
the  various  items  of  expenditure  which  are  necessary  to 
bring  the  land  into  condition  for  use  are  properly  ele- 
ments of  the  book  cost.  When  the  land  is  in  use,  subse- 
quent expenditures  should  be  very  carefully  scanned  to 
determine  whether  they  are  properly  chargeable  to  the 
asset  account  or  whether  they  are  items  of  expense.  An 
expenditure  should  never  be  charged  to  a  fixed  asset 


Assets  and  Their  Valuations  183 

account  such  as  Real  Estate,  unless  it  unquestionably  adds 
real  value  to  the  asset. 

Ordinarily  neither  appreciation  nor  depreciation  of 
land  should  be  taken  into  consideration.  This,  however, 
may  not  be  true  under  certain  special  conditions.  For 
example  consider  the  case  of  a  mining  property  where 
the  amount  of  mineral  is  known.  Every  ton  that  is 
brought  to  the  surface  decreases  the  value  of  the  mining 
property.  Such  a  property  is  known  as  a  "  wasting 
asset, ' '  and  it  is  clear  that  a  consistent  plan  of  amortiza- 
tion must  be  followed  in  such  cases.  If  a  mining  property 
cost  $100,000.00  and  a  careful  estimate  indicates  one  mil- 
lion tons  of  ore,  then  for  every  ten  tons  of  ore  taken  out 
of  the  mine  the  property  would  decrease  $1.00  in  value. 
If  mining  is  conducted  at  the  rate  of  100,000  tons  a  year, 
then  the  property  has  an  approximate  life  of  ten  years 
and  depreciates  $10,000.00  every  year. 

In  such  cases  as  this  the  rate  for  amortizing  all  the 
other  fixed  assets  must  be  based  upon  the  ' '  depreciation 
rate"  of  the  wasting  asset.  In  the  case  above  mentioned 
the  mine  buildings  and  equipment  might  have  an  average 
life  of  twenty-five  years,  but  if  the  mine  has  only  a  life 
of  ten  years,  the  amortization  of  the  mine  buildings  must 
also  be  based  upon  a  ten-year  life,  since  they  will  have  no 
value  when  the  mine  is  exhausted. 

The  rule,  therefore,  in  connection  with  wasting  assets 
like  mines,  is  that  the  depreciation  rate  of  accompanying 
fixed  assets  having  an  estimated  life  less  than  the  life  of 
the  mine  may  base  their  depreciation  rate  upon  estimated 
life,  but  that  fixed  assets  having  an  estimated  life  greater 
than  the  life  of  the  mine  must  be  amortized  at  the  same 
rate  as  the  mine  itself.  Should  this  rule  not  be  strictly 
followed  it  is  clear  that  the  profits  of  any  one  year  may 
consist  partly  of  real  profits  and  partly  of  the  original 


184  Principles  of  Accounting 

capital  invested.  Dividend  declarations  based  on  such 
apparent  profits  would  be  illegal  in  many  states,  since  it 
is  a  fairly  well-settled  rule  that  a  dividend  may  be 
declared  only  out  of  profits. 

LAND  PURCHASED  WITH  STOCKS  OB  BONDS 

Land  is  not  always  purchased  for  cash.  It  is  some- 
times purchased  with  stocks  and  bonds.  When  this  is 
done,  a  very  difficult  problem  arises  as  to  what  the  actual 
cost  of  the  property  is.  Theoretically,  at  least,  a  double 
valuation  must  be  made,  since  the  property  is  valued  in 
terms  of  the  securities  and  the  securities  are  valued  in 
terms  of  cash.  The  proper  theoretical  procedure,  since 
securities  are  seldom,  if  ever,  worth  exactly  par,  would 
be  to  calculate  the  cash  value  of  the  securities  and  then 
to  book  the  land  at  the  cash  value  of  the  securities  with 
which  it  was  purchased.  While  theoretically  correct, 
such  a  procedure  is  not  followed  in  actual  practice.  The 
situation  usually  occurs  in  connection  with  corporations, 
and  the  law  accepts  the  judgment  of  the  directors  as  to 
the  value  of  the  asset  so  acquired.  In  the  absence  of 
fraud  the  judgment  of  the  directors  is  considered  final.7 

BUILDINGS 

The  problems  in  connection  with  the  valuation  of  build- 
ings are  very  similar  to  those  discussed  in  the  foregoing 

7  There  seems  to  be  some  difference  of  opinion  among  lawyers  regard- 
ing the  exchange  of  capital  stock  for  property.  At  common  law  there  are 
two  general  rules — the  "good  faith"  rule  and  the  "true  value"  rule 
but  these  may  be  modified  by  statute  in  the  several  states.  The  "good 
faith"  rule  simply  requires  good  faith  on  the  part  of  the  directors  in 
valuing  the  property,  but  a  gross  overvaluation  is  held  to  be  presumptive 
evidence  of  bad  faith.  The  "true  value"  rule  states  that  the  fair  market 
price  is  the  one  to  be  used  and,  on  behalf  of  the  creditors,  the  court  may 
"go  back"  of  the  directors7  valuation,  regardless  of  their  good  faith.  The 
basis  of  this  rule  is  the  idea  that  the  capital  stock  of  a  corporation  is  a 
trust  fund  for  the  benefit  of  the  creditors. 


Assets  and  Their  Valuations  185 

section,  except  that  where  the  land  account  represents  a 
wasting  asset,  depreciation  should  be  considered,  other- 
wise land  should  be  kept  on'  the  books  at  original  cost. 
A  building,  on  the  other  hand,  must  always  be  depre- 
ciated. 

With  buildings,  as  in  the  case  of  land,  a  very  careful 
distinction  should  be  made  as  to  the  proper  charges  for 
expenditures.  After  the  property  has  been  acquired,  no 
expenditure  should  be  charged  to  the  asset  account,  unless 
it  represents  an  actual  betterment  and  increase  in  the 
value  of  that  asset.  This  distinction  is  sometimes  very 
difficult  to  make.  In  a  going  business  improvements  to 
buildings  are  constantly  made,  repairs  and  replacements 
are  always  under  way,  and  expenditures  for  such  pur- 
poses should  be  carefully  examined  to  determine  whether 
they  are  in  the  nature  of  upkeep  and,  therefore,  charge- 
able to  expense  or  are  bona  fide  improvements  properly 
chargeable  to  the  asset  account.  The  only  safe  rule  to 
follow  is  the  one  previously  laid  down;  viz.,  where  the 
expenditure  results  in  increased  operating  facilities  which 
will  permanently  increase  the  net  profits  of  the  business 
or  permanently  increase  its  real  value  or  permanently 
increase  its  rental  value,  the  proper  charge  is  direct  to 
the  asset  account,  but  where  the  only  effect  of  the  expendi- 
ture is  to  maintain  the  property,  the  proper  charge  is  to 
an  expense  account.  Where  renewals  of  assets  are  more 
valuable  than  the  property  replaced,  the  excess  is  prop- 
erly and  legitimately  chargeable  to  property  accounts. 

Buildings  which  are  constructed  by  the  company  own- 
ing them  should  be  valued  at  the  actual  cost  of  construc- 
tion and  not  at  the  price  which  they  would  have  cost  if 
purchased  from  outside  parties.  The  difference  between 
the  construction  cost  and  the  purchase  price  of  a  building 
is  not  a  profit  but  a  saving. 


186  Principles  of  Accounting 

The  original  amount  at  which  a  building  should  be 
booked  is  its  value  to  the  "going"  concern.  The  proper 
elements  of  that  cost  include  any  expenses  necessarily 
involved  in  constructing  or  purchasing  the  building,  plus 
the  expenditures  which  must  be  made  in  order  to  put  it 
into  condition  for  use.  Examples  of  such  expenditures 
are  building  permit  fees,  legal  fees,  insurance  during  con- 
struction, interest  on  investment  during  construction, 
wages  of  night-watchman  during  construction,  etc. 

LEASEHOLDS 

It  frequently  happens  that  buildings  are  erected  on 
leased  ground.  Depreciation  should,  of  course,  be 
charged  on  such  buildings  based  on  their  estimated  life, 
unless  the  life  of  the  lease  is  less  than  the  estimated  life 
of  the  building.  In  such  a  case  the  cost  of  the  building 
should  be  written  off  over  the  life  of  the  lease.  For  exam- 
ple, assume  that  John  Doe  on  Jan.  1, 1915,  leased  certain 
land  for  twenty-one  years  and  that  he  erected  a  $40,000.00 
building,  which  was  completed  Jan.  1,  1916.  He  esti- 
mated that  the  life  of  the  building  would  be  about  thirty 
years.  What  provision  should  he  make  for  depreciation? 

1.  Yearly  depreciation  charge  based  on  life  of 

$40,000.00   (cost) 

building  = =  $1,333.33 

30         (years  of  life) 

2.  Yearly    depreciation    charge    based    on    life 

$40,000.00  (cost) 

of  lease  = =  $2,000.00 

20         (years  to  run) 

Under  the  first  plan  the  Buildings  Account  will  show 
balance  of  $13,333.34  on  December  31,  1936,  whereas  th< 
actual  value  of  the  building  to  John  Doe  will  be  zero,  indi- 
cating that  his  accounts  have  failed  to  tell  the  trul 


Assets  and  Their  Valuations  187 

Under  the  second  plan  the  cost  of  the  building  will  be  dis- 
tributed over  the  life  of  the  lease,  and  when  the  latter 
expires,  the  cost  of  the  building  will  be  entirely  wiped  off 
the  books. 

If  a  lease  is  purchased,  its  purchase  price  may  be  set 
up  as  an  asset,  to  be  amortized  over  the  number  of  years 
the  lease  has  to  run. 

The  reader  should  understand  that  this  discussion  of 
the  valuation  of  land  and  buildings  assumes  that  such 
assets  are  fixed  in  their  nature.  The  treatment  of  sim- 
ilar items  on  the  books  of  a  real  estate  company  which 
deals  in  land  and  buildings  as  personal  property  is 
entirely  different.  In  that  case  land  and  buildings  are  in 
the  nature  of  merchandise  and  should  be  handled  in  a 
similar  way. 

MACHINEKY 

Machinery,  as  a  fixed  asset,  is  subject  to  the  same  gen- 
eral rules  as  have  been  given  for  the  valuation  of  land 
and  buildings.  Machinery  should  be  charged  to  the  Ma- 
chinery Account  at  cost,  and  this  cost  may  very  properly 
include  the  f.  o.  b.  cost,  plus  the  freight,  plus  the  expense 
of  installation.  As  in  the  case  of  other  assets,  the  value 
of  machinery  is  its  value  to  the  "going"  concern;  hence 
all  expenditures  which  must  necessarily  be  made  before 
the  machine  can  be  put  in  operation  are  properly  included 
in  the  cost  of  that  machine. 

Adequate  provision  for  depreciation  should  be  made  as 
in  the  case  of  buildings.  The  rate  of  depreciation  de- 
pends upon  a  great  many  factors  and  will  in  certain  cases 
have  to  be  determined  by  a  qualified  expert  for  each  indi- 
vidual case. 

Machinery,  which  is  built  by  a  company  for  its  own  use, 
must  be  booked  at  actual  cost,  i.  e.,  materials,  labor,  and 


188  Principles  of  Accounting 

factory  expense.  The  fact  that  such  cost  is  less  than  the 
price  at  which  the  machinery  could  be  purchased  is  no 
argument  in  favor  of  charging  the  asset  account  with  the 
latter.  The  difference  between  actual  cost  and  the  mar- 
ket price  is  not  a  profit  but  a  saving. 

Machinery  that  is  purchased  primarily  for  resale  is 
not  a  fixed  asset  but  is  equivalent  to  merchandise  and  is 
subject  to  the  same  rules  of  valuation. 

INVESTMENTS 

Two  general  classes  of  investments  may  be  recognized ; 
i.  e.,  those  that  are  fixed  assets  in  their  nature  and  those 
held  for  the  purpose  of  resale. 

The  United  States  Government  bonds,  which  are  held 
by  national  banks,  are  permanent  investments.  The  bank 
cannot  continue  its  note-issuing  function  if  the  bonds  are 
disposed  of.  Similarly,  the  investment  which  a  railroad 
company  has  in  smaller  tributary  lines  is  a  fixed  asset. 

From  the  foregoing  two  examples  we  see  that  invest- 
ments may  be  regarded  as  fixed  assets  if  they  are 
essential  to  the  business  in  the  same  way  that  land, 
buildings,  and  machinery  are  essential  to  the  business. 
Securities  that  are  purchased  for  speculation  are  not 
fixed  assets — they  more  nearly  resemble  current  assets. 
Securities  which  a  bond-dealer  has  on  hand  for  the  pur- 
pose of  resale  are  merchandise. 

Investments  may  be  roughly  divided  into  two  broad 
general  classes — stocks  and  bonds — and  the  accounting 
treatment  of  these  two  classes  is  very  different. 

The  treatment  of  stock  purchased  is  simple.  It  may 
be  booked  at  actual  cost,  regardless  of  par  value — the 
fluctuations  in  its  value  may  be  ignored  if  it  is  an  asset 
actually  "  fixed "  in  its  nature.  If  stocks  are  purchased 
for  speculative  purposes  or  as  short-time  investments 


Assets  and  Their  Valuations  189 

DIFFERENCES  BETWEEN   STOCKS   AND  BONDS 

Stocks  Bonds 

Stocks  are  not  liabilities  but  certifi-       Bonds  are  secured  liabilities 

cates  of  ownership 

Stockholders  may  share  in  profits  in       Bondholders  do  not  share  profits  but 

the  form  of  dividends  receive  interest  at  a  definite  rate 

Stockholders    may    share    in    assets       Bondholders  expect  return  of  invest- 

upon  dissolution  of  the  company  ment  intact  at  maturity  according 

to  the  terms  of  the  agreement 
A  share  of  stock  represents  a  pro-       A  bond  is  a  limited  interest  in  a  cor- 

portionate  share  of  assets  poration 

Stockholders  have  control  of  the  cor-       Bondholders  as  long  as  they  receive 
poration  regular   interest  and  principal  at 

maturity  have  no  voice  in  the  man- 
agement 
A  stockholder  is  a  part  owner  A  bondholder  is  a  creditor 

for  idle  funds  or  for  purpose  of  resale,  they  are  equiva- 
lent to  merchandise,  and  the  rule  of  "cost  or  market 
price,  whichever  is  lower,"  applies. 

Bonds  which  are  purchased  for  a  permanent  investment 
and  which  are  equivalent  to  fixed  assets,  may  be  bought 
either  at  par,  below  par,  or  above  par.  If  they  are  bought 
at  par,  they  are  booked  at  cost  and  allowed  to  remain  at 
that  figure  until  maturity.  If  they  are  bought  above 
par  (at  a  premium),  they  may  be  booked  at  cost;  but  the 
excess  of  cost  over  par  value  must  be  amortized — written 
off  during  the  life  of  the  bond.  The  theory  underlying 
this  doctrine  is  that  the  premium  merely  represents  bond 
interest  purchased  in  advance  which  must  be  applied 
against  the  actual  interest  received  during  the  life  of 
the  bond.  For  example,  suppose  a  $1,000.00  bond,  run- 
ning for  25  years  with  interest  rate  of  5%,  is  purchased 
at  a  price  of  $1,250.00.  The  yearly  interest  which  will  be 
received  is  $50.00,  but  the  actual  or  effective  interest 
which  will  be  earned  is  $40.00,  because  each  year  the 
book  value  of  the  bond  must  be  depreciated  $10.00,  so 
that  at  the  end  of  last  year  its  book  value  will  only  appear 


190  Principles  of  Accounting 

as  $1,000.00.  This  is  the  amount  which  will  be  received 
in  cash  when  the  bond  is  called  for  payment.  The  reason 
why  the  bond  sold  for  more  than  par  is  because  a  5% 
return  was  considered  too  high  a  return  on  a  bond  of 
such  class.  The  holder  of  such  a  high-class  bond  is  not 
willing  to  sell  it  at  par  because  it  gives  him  such  good 
return  for  his  money.  If,  however,  he  sells  it  for 
$1,250.00,  he  implies  that  a  4%  return  is  sufficient  and, 
therefore,  sells  it  on  a  4%  basis.  The  purchaser  of  the 
bond  by  paying  such  a  premium  impliedly  admits  that 
a  4%  basis  is  correct  but,  since  the  bond  actually  returns 
5%  on  par,  he  pays  the  holder  of  the  bond  an  amount 
sufficient  to  make  the  return  on  his  own  investment 
approximately  4%.  When  the  bond  is  paid  off  by  the 
company  issuing  it,  it  will  pay  only  $1,000.00.  There- 
fore, the  $250.00  premium  must  be  equitably  spread  over 
the  life  of  the  bond,  and  the  yearly  amount  written  off 
must  be  treated  as  a  deduction  from  the  income  received. 
To  be  strictly  logical,  bonds  purchased  at  a  discount, 
i.  e.,  below  par,  should  be  marked  up  each  year,  and  there 
is  no  particular  reason  from  a  theoretical  point  of  view 
why  this  may  not  be  done.  Many  accountants  object, 
however,  to  such  procedure  on  the  ground  that  it  is 
dangerous  to  permit  marking  up  the  values  of  fixed 
assets.  They  always  insist  on  taking  depreciation  into 
account  but  seldom,  if  ever,  are  willing  to  allow  appre- 
ciation. Hence,  it  is  usually  customary  to  book  such 
bonds  at  actual  cost  and  to  hold  them  at  that  figure  until 
the  bonds  are  paid ;  thus,  a  $1,000.00  bond  due  in  ten  years 
at  5%  interest  if  purchased  for  $880.00  will  be  left  at 
that  figure  for  the  entire  ten  years.  At  the  end  of  the 
last  year,  in  addition  to  the  $50.00  interest,  there  woulc 
be  a  $120.00  increase  in  the  value  of  the  asset,  bringing 
it  up  to  par  value.  Such  an  extraordinary  profit  Occur- 


Assets  and  Their  Valuations  191 

ring  in  one  accounting  period  should,  under  no  circum- 
stances, be  treated  as  profit  of  that  period,  but  should 
be  credited  direct  to  a  capital  account. 

The  accountancy  of  investment  is  a  science  in  itself, 
and  it  would  serve  no  useful  purpose  to  discuss  it  here. 
There  have  been  several  excellent  manuals  written  on 
the  subject,  the  principal  one  being  Accountancy  of 
Investment,  by  Chas.  E.  Sprague,  which  gives  a  detailed 
presentation  of  the  calculation  of  interest,  annuities,  bond 
valuations  at  varying  rates,  and  amortization. 

DEFERRED  ASSETS 

Very  little  difference  of  opinion  can  exist  as  to  the 
principles  of  valuing  deferred  assets.  A  deferred  asset 
is  a  prepayment,  and  its  original  value  is  equal  to  its 
cost.  If  correctly  handled,  each  deferred  asset  appears 
at  a  value  which  constantly  diminishes  as  time  goes  on 
until  it  is  finally  extinguished  altogether.  Development 
expense  in  connection  with  mines  and  experimental  ex- 
pense in  factories  are  good  examples  of  deferred  assets. 
In  every  case,  deferred  assets  should  be  written  off 
against  the  accounting  periods  to  which  the  expense  is 
properly  chargeable. 

INTANGIBLE  FIXED  ASSETS 

When  a  business  is  sold,  it  frequently  happens  that 
the  price  received  for  it  is  considerably  in  excess  of  its 
net  worth  as  shown  by  the  books.  The  difference  be- 
tween the  net  worth  and  the  price  actually  received  is 
often  spoken  of  as  "  goodwill. ' '  Goodwill  is  made  up  of 
a  number  of  elements.  It  takes  into  consideration  the 
loyalty  of  constant  customers  and  the  force  of  habit 
which  causes  them  to  continue  trading  at  one  place. 
When  an  individual  gets  into  the  habit  of  trading  at 


192  Principles  of  Accounting 

one  particular  place  of  business,  he  is  a  far  more  valuable 
customer  than  the  one  who  must  be  attracted  by  means 
of  expensive  advertising  and  selling  effort.  Concerns 
that  have  been  in  business  for  a  long  time  gradually 
accumulate  a  clientele  of  satisfied  customers.  The  busi- 
ness which  has  such  a  well-established  patronage  is  worth 
considerably  more  than  a  business  with  a  similar  net 
worth  which  has  none. 

GOODWILL 

Goodwill  is  defined  by  Webster's  New  International 
Dictionary  as  "the  custom  of  any  trade  or  business;  the 
favor  or  advantage  in  the  way  of  custom  which  a  business 
has  acquired  beyond  the  mere  value  of  what  it  sells, 
whether  due  to  the  personality  of  those  conducting  it,  the 
nature  of  its  location,  its  reputation  for  skill,  prompti- 
tude, etc.,  or  any  other  circumstance  incidental  to  the 
business  and  tending  to  make  it  permanent. "  The 
Treasury  Department  of  the  United  States  has  given 
the  following  short  definition,  "Goodwill  represents  the 
value  attached  to  a  business  over  and  above  the  value 
of  the  physical  property.''  Goodwill  represents  the 
value  of  the  physical  organization  of  a  business,  its 
trade-marks,  its  advertising,  and  its  relationship  with 
others. 

When  a  business  is  purchased  for  more  than  its  net 
worth,  the  difference  between  its  net  worth  and  the 
purchase  price  may  be  charged  to  the  Goodwill  Account. 
This  goodwill  then  appears  on  the  Ledger  as  an  asset, 
and  it  may  rightfully  be  so  considered.  It  represents  the 
purchase  of  something  which  would  otherwise  have  to  be 
acquired  by  the  expenditure  of  money  for  advertising, 
salesmen,  etc.  That  concern  which  is  able  to  purchase 
a  crowd  of  satisfied  customers — customers  who  will  be 


Assets  and  Their  Valuations  193 

likely  to  continue  trading  where  they  have  traded  in  the 
past — will  certainly  have  to  spend  less  money  in  adver- 
tising than  a  concern  which  has  to  build  up  an  entirely 
new  clientele. 

Theoretically,  goodwill  should  appear  on  the  books  of 
a  concern  as  an  asset  when  that  concern  begins  to  make 
more  than  a  normal  rate  of  return  on  the  capital  invested, 
and  as  the  concern  gets  more  prosperous  and  its  actual 
goodwill  increases,  it  would  be  theoretically  justified  in 
increasing  its  Goodwill  Account.  This,  however,  is  re- 
garded as  a  very  dangerous  procedure,  and  no  reputable 
accountant  would  permit  it.  A  well-established  rule  is 
that  goodwill  shall  not  appear  as  an  asset,  unless  it  has 
been  purchased.  John  Jones  may  have  a  business  with 
a  net  worth  of  $10,000.00.  That  business  may  be  actually 
worth  $30,000.00  from  an  income-producing  standpoint, 
but  Jones  will  not  be  allowed  to  set  up  goodwill  of 
$20,000.00.  However,  if  Smith  purchases  the  business 
from  him  for  $30,000.00,  Smith  may  book  goodwill  as 
being  worth  $20,000.00  without  being  criticized.  The 
reason  for  this  is  that  Smith  has  demonstrated  his  belief 
in  the  existence  of  goodwill  by  paying  cash  for  it. 

Some  question  exists  as  to  whether  goodwill  should 
remain  permanently  an  asset  or  whether  it  should  be 
charged  off  against  profits  year  by  year  until  finally 
extinguished.  There  are  several  ways  of  looking  at  this 
matter.  Some  accountants  declare  that  goodwill  should 
be  charged  against  the  profits  for  which  it  is  responsible. 
This  assumes  that  the  only  value  which  goodwill  has  is 
that  of  a  profit-producer.  As  extraordinary  profits  are 
made  which  are  clearly  due  to  goodwill,  then  that  goodwill 
should  be  charged  against  those  profits. 

Some  accountants  consider  it  allowable  to  retain  good- 
will indefinitely  upon  the  books;  they  claim  that' its 


194  Principles  of  Accounting 

appearance  in  the  balance  sheets  deceives  no  one,  that 
it  represents  very  little  more  than  a  bookkeeping  con- 
venience, and  that  it  should  not  be  allowed  to  disturb 
profits. 

Still  other  authorities  consider  that  goodwill  should 
be  charged  off  during  prosperous  years  and  not  during 
lean  years.  This  is  fallacious,  since  if  no  profits  are 
made  it  is  apparent  that  goodwill  is  valueless  and  should, 
therefore,  be  charged  off.  If  extraordinary  profits  are 
made,  it  is  pretty  good  evidence  that  the  goodwill  is 
worth  face  value  or  more  and  should,  therefore,  not  be 
charged  off  at  all.  Following  such  a  logical  line  of  rea- 
soning it  leads  to  the  absurdity  of  charging  off  goodwill 
during  unprofitable  years  and  thus  further  increasing  the 
loss  and  of  not  charging  it  off  during  the  years  when 
the  business  could  best  afford  it. 

The  author  submits  the  following  as  being  a  logical 
method  of  treating  goodwill.  When  goodwill  is  pur- 
chased, it  is  paid  for  on  the  same  basis  as  any  other 
asset,  namely,  its  inherent  value  to  the  purchaser.  The 
purchaser  either  does  or  does  not  get  his  money 's  worth. 
If  he  does  get  his  money's  worth,  it  will  be  indicated  by 
substantial  profits,  since  goodwill  that  does  not  produce 
profits  has  no  value.  If  large  profits  are  made  during 
the  first  few  years,  then  the  goodwill  should  be  amortized 
during  those  years.  If  the  expected  profits  do  not 
materialize,  it  is  a  sign  that  the  investment  was  an  unfor- 
tunate one  and  that  the  purchaser  did  not  get  value 
received  for  his  money,  or  that  he  did  get  value  received 
but  that  the  goodwill  disappeared  because  of  some  fault 
of  his  own.  In  either  case  the  goodwill  should  be  charged 
off  not  against  current  profits  but  against  the  capital 
invested.  The  situation  is  analogous  to  the  purchase 
of  a  business  purporting  to  own  certain  assets  which  do 


* 


Assets  and  Their  Valuations  195 

not  exist.  When  it  is  determined  that  these  assets  do 
not  actually  exist,  they  will  not  be  charged  against  current 
profits  but  will  be  charged  against  the  capital  account. 
The  question  as  to  the  period  of  time  over  which  goodwill 
should  be  written  off  resolves  itself  back  to  the  question 
' t  What  has  been  purchased f  "  Clearly  nothing  has  been 
purchased  save  anticipated  profits.  The  purchase  of  a 
business  at  a  premium  is  very  much  like  the  purchase 
of  a  bond  at  a  premium.  The  bond  premium  represents 
future  interest ;  the  business  premium  or  goodwill  repre- 
sents future  profits.  Since  the  rate  of  amortization  of 
bond  premium  is  dependent  upon  the  time  factor,  the  life 
of  the  bond  determines  the  yearly  amount  to  be  charged 
off.  In  the  case  of  goodwill  the  number  of  years'  profits 
which  have  been  purchased  determines  the  number  of 
years  over  which  goodwill  shall  be  charged  off. 

No  one  can  afford  to  be  dogmatic  about  the  treatment 
of  goodwill.  So  many  excellent  authorities  disagree 
absolutely  as  to  the  treatment  of  goodwill  that  it  would 
seem  as  if  almost  any  of  the  methods  discussed  would 
be  justifiable. 

FKANCHISES  AND  PATENTS 

Franchises  and  patents  are  usually  classed  with 
goodwill.  Payment  for  a  patent  is  nothing  more  than 
payment  for  protection.  It  may  be  set  up  as  an  asset, 
but  it  normally  should  be  written  off  in  equal,  annual 
installments  over  the  life  of  the  patent.  The  payment 
for  a  franchise  is  also  an  asset  which  should  be  written 
off  in  equal  annual  installments  during  the  life  of  a 
franchise.  Franchises  may  be  perpetual  in  their  nature, 
in  which  case  they  need  not  be  amortized;  but  when  a 
franchise  has  a  definite  number  of  years  to  run,  sound 
accounting  policy  calls  for  its  amortization. 


196  Principles  of  Accounting 

OKGANIZATION  EXPENSE 

When  a  corporation  is  organized,  certain  expenses  are 
always  necessary  before  the  corporation  is  in  shape  to 
do  business.  Fees  must  be  paid,  expenses  must  be  met, 
stationery  and  printing  must  be  paid  for.  All  these  are 
legitimate  charges  to  asset  accounts,  since  they  must  be 
incurred  before  the  corporation  can  begin  business. 
Such  pre-existence  expenses  are  bona  fide  assets  which 
need  never  be  amortized  or  charged  off,  since  they  are 
perpetual  in  their  nature,  unless  the  life  of  the  corpora- 
tion is  limited  to  a  definite  number  of  years,  in  which 
case  they  should  be  charged  off  during  the  life  of  the 
corporation.  The  proper  method  of  booking  such  charges 
is  to  debit  them  to  an  account  called  "Organization  Ex- 
penses/' Many  concerns  do  not  like  to  show  this  item 
quite  so  openly  and,  therefore,  make  the  charge  to  one 
of  the  fixed  asset  accounts,  such  as  Land,  Buildings,  or 
Machinery.  This  is  not  considered  the  best  practice  but 
it  is  allowable,  owing  to  the  sanction  which  custom  has 
given  it. 

TEST  QUESTIONS 

1.  What  is  the  fundamental  rule  of  asset  valuation? 

2.  Outline  the  procedure  for  material  accounting. 

3.  Differentiate  between  weighted  and  straight  averages. 

4.  What  are  the  components  of  raw  material  value? 


CHAPTER  VI 

LIABILITIES 

It  has  already  been  stated  that  liabilities  are  negative 
assets.  A  positive  asset  is  owned.  A  negative  asset  is 
owed.  For  purposes  of  discussion  liabilities  may  be 
classified  into 

1.  Current. 

2.  Long  time. 

3.  Deferred. 

4.  Contingent. 

5.  Proprietary. 

The  first  four  items  are  true  liabilities.  The  fifth  is  a 
liability  only  in  the  bookkeeping  sense,  as  has  previously 
been  explained.  Treatment  of  proprietary  liabilities  will 
be  deferred  until  the  following  chapter. 

CURRENT  LIABILITIES 

Current  liabilities  usually  are  those  having  an  early 
due-date.  In  other  words,  they  are  liabilities  which  must 
be  paid  shortly  after  date  of  the  balance  sheet  upon  which 
they  appear,  although  this  is  not  necessarily  true. 
Strictly  speaking,  all  debts  that  are  not  raised  for 
permanent  purposes  are  current  liabilities.  From  the 
viewpoint  of  the  banker  or  credit  man,  however,  any 
liability  is  current  that  has  an  early  due-date.  All  other 
liabilities,  whether  funded  or  not,  are  considered  "  long- 
time "  obligations. 

In  the  ordinary  business,  current  liabilities  will  consist 

197 


198  Principles  of  Accounting 

mainly  of  two  general  classes  of  items,  i.  e.,  accounts 
payable  and  notes  payable.  An  "account  payable "  is 
an  implied,  verbal,  or  informal  promise  to  pay.  A  * '  note 
payable "  is  a  definite  written  promise  to  pay.  Practi- 
cally no  problems  of  importance  need  be  discussed  with 
reference  to  the  Accounts  Payable  Account.  Normally 
this  is  a  controlling  account  over  a  creditor's  ledger 
(which  may  be  in  ledger  form  or  in  the  form  of  a  voucher 
file).  No  question  of  valuation  is  present,  since  liabilities 
do  not  diminish  in  value  with  the  passage  of  time.  The 
figures  at  which  they  are  booked  remain  the  same  until 
payment  is  made  (either  in  cash,  notes,  or  allowances). 

ACCRUED  LIABILITIES 

In  the  preceding  chapter  the  subject  of  accrued  assets 
was  discussed  at  some  length.  Accrued  liabilities  are 
of  the  same  general  nature  except  that  they  are  nega- 
tive instead  of  positive.  Accrued  liabilities  are  those 
depending  upon  the  passage  of  time  regardless  of  the 
due-date,  and  they  consist  of  such  items  as  accrued  wages 
payable,  accrued  salaries  payable,  accrued  interest  pay- 
able, accrued  taxes  payable,  etc.  Accrued  liabilities  are 
booked  by  means  of  an  adjusting  journal  entry  at  the 
end  of  each  accounting  period.  This  entry  charges 
the  expense  accounts  and  credits  the  accrued  liability 
accounts. 

The  purpose  of  such  entries  is  to  include  among  the 
expenses  of  any  accounting  period  all  items  which  are 
properly  chargeable  against  that  period  and  to  include 
among  the  liabilities  at  the  end  of  the  period  the  amounts 
which  have  accrued  to  that  date,  even  though  the  time  for 
payment  has  not  arrived.  For  example,  it  may  be  the 
practice  to  pay  employees  every  Saturday,  but  the  yearly 
accounting  period  may  end  on  Wednesday.  The  wages 


Liabilities  199 

earned  by  employees  on  Monday,  Tuesday,  and  Wednes- 
day would  be  properly  chargeable  as  expenditures  of  the 
accounting  period.  They  would  also  be  liabilities,  since 
they  have  unquestionably  been  earned  by  the  employees 
and  are  due  to  them.  If  these  accrued  wages  equaled 
$300.00,  the  adjusting  journal  entry  would  debit  Wages 
Account  (an  expense  account)  and  credit  Accrued  Wages 
Payable  (liability  account)  for  $300.00.  It  should  be 
noted  that  such  accrued  items  are  in  the  nature  of  nega- 
tive, or  liability,  inventories. 

It  is  usually  customary  at  the  beginning  of  the  fol- 
lowing accounting  period  to  reverse  the  entries  by  which 
the  accrued  liabilities  were  booked  and  then  to  charge 
the  actual  cash  payment  to  the  expense  account  instead 
of  to  the  accrued  liability  account.  This  need  not  be 
done,  however,  since  it  is  equally  proper  to  charge  the 
disbursement  of  cash  to  the  accrued  liability  account. 

OTHEK  CURRENT  LIABILITIES 

When  a  corporation  declares  a  dividend,  that  dividend 
is  a  liability  of  the  corporation  to  the  stockholders  and 
must  be  set  up  on  the  books.  This  is  done  by  means 
of  a  debit  to  Profit  and  Loss  (or  Undivided  Profits  or 
Surplus)  and  a  credit  to  Dividends  Payable  Account. 
When  the  dividends  are  actually  paid  in  cash,  Dividends 
Payable  Account  will  be  debited,  thus  wiping  out  the 
liability,  and  Cash  will  be  credited.  Dividends  Payable 
might  be  classified  as  "accounts  payable/'  but  for  balance 
sheet  purposes  it  is  usually  desirable  to  show  it  as  a 
separate  item. 

DEFERRED  LIABILITIES 

A  deferred  liability  is  nothing  more  than  a  deferred 
credit  to  Income.  The  philosophy  underlying  this  class 


200  Principles  of  Accounting 

of  liabilities  is  similar  to  that  discussed  in  connection 
with  deferred  assets.  They  represent  liabilities  not 
ultimately  payable  in  cash  but  in  goods  or  services. 
Such  items  as  sales  paid  for  in  advance,  deposits  on 
contracts,  etc.,  are  classified  as  deferred  liabilities. 
They  will  ultimately  appear  as  items  of  Income  but  are 
liabilities  until  earned. 

CONTINGENT  LIABILITIES 

A  contingent  liability,  as  its  name  implies,  is  uncertain. 
It  represents  a  possibility  that  an  amount  will  have  to 
be  paid,  or  a  responsibility  which  may  lead  to  the  creation 
of  an  unconditional  liability.  The  best  example  of  a 
contingent  liability  is  found  in  the  case  of  discounted 
notes  receivable.  A  company  which  receives  many  notes 
from  its  customers  may  find  that  it  is  tying  up  a  goodly 
portion  of  its  capital  in  these  notes  receivable.  Since 
notes  receivable  are  a  real  asset,  they  may  be  sold,  in 
which  case  it  would  seem  natural  to  debit  Cash  for  the 
amount  received  and  to  credit  Notes  Receivable  (disre- 
garding the  loss  due  to  discount).  Such  an  entry,  how- 
ever, will  not  tell  the  exact  truth.  The  notes  are  sold,  but 
a  responsibility  still  exists  in  connection  with  those  notes. 
In  disposing  of  them  the  seller  must  indorse  them,  and 
in  law  such  an  indorsement  acts  qualifiedly  as  a  guarantee. 
This  means  that  if  the  maker  of  the  note  does  not  pay  it, 
the  indorser  may  have  to  do  so.  The  entry,  debiting  Cash 
and  crediting  Notes  Eeceivable,  does  not  show  the  exist- 
ence of  this  contract  of  indorsement. 

One  way  to  handle  this  is  to  make  the  entry  as  above 
indicated  but  to  insert  a  footnote  to  the  balance  sheet 
calling  attention  to  the  fact  that  a  contingent  liability 
exists  for  ' '  Notes  Eeceivable  Discounted. ' '  A  still  better 


Liabilities 


201 


plan  is  to  indicate  this  current  liability  right  in  the 
Ledger  itself.  This  may  be  done  by  omitting  the  entry 
charging  Cash  and  crediting  Notes  Eeceivable  and  sub- 
stituting therefor  an  entry  debiting  Cash  and  crediting 
Notes  Receivable  Discounted.  The  Ledger  will  then  show 
two  misstatements.  It  will  overstate  the  amount  of  notes 
receivable  as  an  asset  and  will  also  show  an  equal  amount 
set  up  as  an  offset  thereto  on  the  liability  side.  For 
balance  sheet  purposes  the  balance  of  Notes  Receivable 
Discounted  Account  should  not  appear  as  a  liability  but 
as  a  deduction  from  the  total  of  Notes  Receivable,  the  net 
amount  being  extended  into  the  asset  column. 

(First  Method) 
BALANCE  SHEET  BEFORE  DISCOUNTING  NOTES 


Cash $  2,000.00 

Notes  Receivable 20,000.00 

Other  Assets 25,000.00 


$47,000.00 


Accounts  Payable $  7,000.00 

Capital    40,000.00 


$47,000.00 


JOURNAL  ENTRY 

Cash   $12,000.00 

Notes  Receivable $12,000.00 


BALANCE  SHEET  AFTER  MAKING  ABOVE  ENTRY 


Cash $14,000.00 

Notes  Receivable 8,000.00 

Other  Assets 25,000.00 


$47,000.00 


Accounts  Payable $  7,000.00 

Capital    40,000.00 


$47,000.00 


The  contingent  liability  of  $12,000.00  for  notes  receiv- 
able discounted  is  not  shown  on  this  balance  sheet. 


202 


Principles  cff  Accounting 


(Second  Method) 
BALANCE  SHEET  BEFORE  DISCOUNTING  NOTES 


Cash $  2,000.00 

Notes  Eeceivable 20,000.00 

Other  Assets 25,000.00 


$47,000.00 


Accounts  Payable $  7,000.00 

Capital    40,000.00 


$47,000.00 


JOURNAL  ENTRY 

Cash    $12,000.00 

Notes  Eeceivable  Discounted $12,000  00 

BALANCE  SHEET  AFTER  MAKING  ABOVE  ENTRY 


Cash  $14,000.00 

Notes  Receivable 20,000.00 

Other  Assets 25,000.00 


$59,000.00 


Accounts  Payable $  7,000.00 

Notes    Eeceivable    Dis- 
counted      12,000.00 

Capital    40,000.00 


$59,000.00 


or  a  better  form  of  balance  sheet  presentation  would  be 

BALANCE  SHEET 


Cash  $14,000.00 

Notes  Eeceiv- 
able   $20,000.00 

Less  —  Notes 
Discounted..  12,000.00  8,000.00 


Other  Assets   25,000.00 


$47,000.00 


Accounts  Payable 
Capital 


.$  7,000.00 
.   40,000.00 


$47,000.00 


There  are  other  kinds  of  contingent  liabilities  which 
occur  less  frequently  than  notes  receivable  discounted, 
and  it  is  usual  to  indicate  their  existence  only  by  means 
of  footnotes  on  the  balance  sheet  Such  contingent  lia- 


Liabilities  203 

bilities  occur  in  connection  with  guarantees  of  various 
kinds. 

BONDED  INDEBTEDNESS 

When  a  corporation  desires  to  raise  money,  it  may 
place  a  mortgage  on  certain  of  its  properties.  Such  a 
mortgage  is  the  same  instrument  that  the  ordinary  indi- 
vidual executes,  but  owing  to  the  difficulty  of  selling 
mortgages  in  inconvenient  amounts  it  is  customary  for 
corporations  to  make  the  mortgage  payable  to  a  trust 
company  who  acts  as  a  trustee.  Bonds  are  then  issued 
in  round  amounts,  i.  e.,  $100.00,  $500.00,  or  $1,000.00. 
These  bonds  are  promises  to  pay  secured  by  the  mortgage 
held  by  the  trustee. 

A  bond  contains  a  promise  to  pay  a  definite  sum  of 
money  at  the  end  of  a  certain  period,  and  the  interest 
rate  is  named  on  the  face  of  the  bond.  When  bonds  are 
sold,  the  bond  account  is  credited,  and  Cash  is  debited 
for  the  amount  realized. 

It  is  clear  that  the  face  or  par  value  of  the  bond  may 
not  be  equal  to  its  real  value.  The  purchaser  of  a  bond 
after  taking  into  consideration  the  number  of  years  it 
has  to  run  and  the  interest  rate,  may  feel  that  the  bond 
is  not  worth  par  value  to  him.  It  may  be  only  worth 
95%  of  par  value.  On  the  other  hand,  a  bond  may  be 
easily  worth  more  than  par  value,  particularly  when  the 
specified  interest  rate  is  high.  The  price  of  a  sound  bond 
is  determined  by  its  actual  return  of  rate,  and  there  is 
always  some  interest  rate  at  which  any  bond  can  be  sold 
for  exactly  par.  The  interest  rate  being  fixed,  the  only 
way  to  obtain  a  different  rate  on  the  investment  is  to 
adjust  the  price  paid  for  the  bond.  Suppose  a  hundred- 
year  bond  was  issued  with  a  par  value  of  $1,000.00  at  an 
interest  rate  of  4%,  the  annual  return  will  evidently  be 


204  Principles  of  Accounting 

$40.00.  If  the  current  rate  for  money  is  5%,  the  bond 
can  be  sold  for  approximately  $800.00,  since  $40.00  a 
year  is  5%  of  $800.00. 

Suppose,  on  the  other  hand,  that  the  same  bond  was 
offered  for  sale  at  a  specified  interest  rate  of  6%.  The 
income  from  such  a  bond  would  be  $60.00  a  year,  but  if 
the  current  market  rate  for  money  was  in  the  neighbor- 
hood of  5%,  the  company  issuing  this  bond  could  probably 
sell  it  for  more  than  par,  or  around  $1,200.00.  The  reader 
should,  therefore,  discriminate  between  the  two  kinds  of 
interest  rate.  The  nominal  interest  rate  is  the  one  indi- 
cated on  the  face  of  the  bond.  The  effective  or  real 
interest  rate  is  the  actual  rate  of  return  on  the  invest- 
ment and  is  roughly  obtained  by  dividing  the  annual  cash 
income  by  the  actual  cash  investment.  In  the  last 
example  shown  above  the  nominal  interest  rate  was  6%, 
and  the  effective  interest  rate  was  5%.  The  reader 
should  have  no  difficulty  in  realizing  that  if  he  buys  a 
bond  for  less  than  the  par  value,  which  guarantees  a  fixed 
yearly  rate,  the  annual  rate  of  interest  on  his  actual 
investment  will  be  greater  than  the  nominal  interest 
specified  on  the  face  of  the  bond. 

The  company  issuing  a  bond  must  book  it  at  par  value, 
since  the  par  value  always  constitutes  the  real  ultimate 
liability.  The  entry  to  Cash  for  the  proceeds  of  the  bond 
sale  will  probably  be  either  more  or  less  than  the  credit 
to  the  Bond  Account,  since  we  have  seen  that  few  bonds 
are  really  sold  at  exactly  par.  The  difference  between 
the  liability  thus  set  up  and  the  cash  received  must  cer- 
tainly be  recorded  on  the  books.  This  can  best  be  illus- 
trated by  a  series  of  examples.  Suppose  a  company  has 
the  following  balance  sheet: 


Liabilities 


205 


BALANCE  SHEET 


Cash $  4,000.00 

Plant  50,000.00 

Other  Assets    20,000.00 


$74,000.00 


Accounts  Payable $15,000.00 

Capital  &  Surplus 59,000.00 


$74,000.00 


The  company  decides  to  sell  bonds  in  order  to  raise 
money  for  an  extension  of  its  plant.  After  proper  legal 
formalities,  it  issues  $25,000.00  worth  of  5%  ten-year 
bonds.  Let  us  suppose  that  it  is  able  to  sell  these  bonds 
for  only  $20,000.00. 

Cash  will  be  debited  $20,000.00,  Bonds  Payable  will  be 
credited  $25,000.00,  and  $5,000.00  entry  will  have  to  be 
made  to  the  debit  of  a  new  account  which  we  may  call 
"Discount  on  Bonds." 

The  journal  entry  for  this  transaction  will  appear  as 
follows : 

Cash   $20,000.00 

Discount  on  Bonds   5,000.00 

Bonds  Payable $25,000.00 

When  the  entries  have  been  posted,  the  following 
balance  sheet  will  result: 

BALANCE  SHEET 


Cash  $24,000.00 

Discount  on  Bonds 5,000.00 

Plant    50,000.00 

Other  Assets 20,000.00 


),000.00 


Accounts  Payable $15,000.00 

Bonds  Payable 25,000.00 

Capital  &  Surplus 59,000.00 


$99,000.00 


This  item  of  discount  on  bonds  is  a  deferred  charge 
to  the  Interest  Account.  The  company  assumed  a  lia- 
bility of  $25,000.00  but  received  only  $20,000.00.  This 
would  indicate  that  the  rate  of  return  specified  on  the 


206  Principles  of  Accounting 

face  of  the  bond  was  insufficient  to  attract  the  purchaser. 
The  issuer  of  the  bond,  therefore,  was  obliged  to  increase 
the  rate  of  interest.  This  was  done  by  paying  a  certain 
portion  of  the  interest  in  advance.  This  will  be  readily 
grasped  after  we  analyze  the  above  journal  entry.  It 
consists  of  a  sale  of  $25,000.00  worth  of  bonds  for 
$25,000.00  in  cash  and  the  payment  of  $5,000.00  in  cash 
to  the  purchaser  of  the  bonds  in  prepayment  of  interest. 
In  journal  entry  form  this  will  appear  as  follows : 

Cash $25,000.00 

Bonds  Payable $25,000.00 

To  record  sale  of  bonds 

Discount  on  Bonds 5,000.00 

Cash 5,000.00 

To  record  the  prepayment  of  interest 

The  interest  on  such  bonds  is,  therefore,  paid  in  two 
ways:  (1)  A  portion  of  it,  amounting  in  this  example 
to  $5,000.00,  is  paid  in  advance,  and  (2)  the  balance  is 
paid  at  the  rate  of  $1,250.00  a  year  (a  total  of  $12,500.00 
during  the  life  of  the  bond).  The  total  interest  on  these 
bonds  actually  paid  in  cash  is  $17,500.00,  $5,000.00  of  it 
being  paid  in  advance  and  the  balance  being  paid  in 
yearly  installments.  The  important  thing  is  that  this 
item  of  discount  on  bonds  represents  nothing  more  than 
a  prepayment  of  the  interest  and  can,  therefore,  be  classed 
as  a  deferred  asset  which  must  be  charged  off  during 
the  life  of  the  bonds  in  equal  annual  amounts.1  At  the 
end  of  each  year,  therefore,  two  entries  will  have  to  be 

i  It  has  not  been  thought  desirable  to  discuss  the  intricacies  of  this 
subject  but  to  confine  the  discussion  to  an  exposition  of  underlying  principles. 
Whether  this  item  of  discount  on  bonds  is  charged  off  in  equal  annual  in- 
stallments or  according  to  some  other  plan  has  no  effect  on  the  principle 
involved,  and  for  purposes  of  clear  presentation  it  is  much  simpler  to 
assume  uniform  amortization. 


Liabilities 


207 


made,  one  entry  will  credit  Discount  on  Bonds  and  debit 
Interest  Account  for  the  annual  amount  written  off,  and 
the  other  entry  will  credit  Cash  and  debit  Interest  for 
the  installment  paid  in  cash. 

Interest  on  Bonds $500.00 

Discount  on  Bonds $500.00 

To  charge  off  yearly  installment  on  bond  discount 

Interest  on  Bonds 1,250.00 

Cash  1,250.00 

To  pay  the  nominal  interest  at  the  rate  of  5%  on  par  value  of  bonds 
outstanding 

The  account,  Interest  on  Bonds,  represents  real  or 
effective  interest,  the  item  of  $1,250.00  being  the  nominal 
interest. 

Bonds  issued  at  a  premium  are  handled  according  to 
the  same  principles  that  have  been  outlined  for  bonds 
issued  at  a  discount.  For  purposes  of  illustration,  we 
may  use  the  same  starting  balance  sheet  that  was  shown 
on  the  preceding  page. 

BALANCE  SHEET 


Cash $  4,000.00 

Plant  50,000.00 

Other  Assets 20,000.00 


$74,000.00 


Accounts  Payable $15,000.00 

Capital  &  Surplus 59,000.00 


$74,000.00 


The  same  5%  ten-year  bonds  are  sold,  but  the  price 
obtained  for  them  is  $30,000.00.  It  is  clear  that  Cash 
must  be  debited  with  the  amount  of  cash  received  and 
that  the  liability  account,  Bonds  Payable,  must  be  credited 
for  the  par  of  the  bonds  sold  or  $25,000.00.  The  differ- 
ence between  these  two  figures  represents  premium  on 
bonds  and  is  a  deferred  credit  item,  representing  income 
received  but  not  earned. 


208 


Principles  of  Accounting 


BALANCE  SHEET 


Cash  $  34,000.00 

Plant 50,000.00 

Other  Assets    20,000.00 


$104,000.00 


Accounts  Payable $  15,000.00 

Bonds  Payable 25,000.00 

Premium  on  bonds 5,000.00 

Capital  &  Surplus 59,000.00 


$104,000.00 


Analysis  indicates  that  the  nominal  rate  of  interest 
specified  on  the  face  of  the  bonds  was  in  excess  of  the 
amount  of  interest  it  would  actually  be  necessary  to  pay 
for  the  use  of  the  money.  Instead  of  reducing  the 
nominal  interest  rate  they  sell  the  bonds  for  more  than 
par.  The  difference  between  the  sales  price,  $30,000.00, 
and  the  par  value,  $25,000.00,  represents  money  that  the 
purchasers  of  the  bonds  have  paid  to  the  company.  It 
really  represents  a  refund  by  them  of  interest  which  they 
expect  to  receive.  The  company  is  then  in  a  position  of 
having  received  as  a  refund,  interest  which  it  has  not 
yet  paid  but  has  only  promised  to  pay.  It  must  set  the 
amount  up  as  a  deferred  liability  and  write  it  off  during 
the  life  of  the  bond  in  equal  annual  installments.  Each 
year  one-tenth  of  the  premium  will  be  debited  to  Premium 
on  Bonds  and  credited  to  Bond  Interest.  At  the  same 
time  Cash  will  be  credited  and  Bond  Interest  debited  for 
the  interest  actually  paid  at  the  nominal  rate  (which  is 
greater  than  the  real,  or  effective,  rate). 

In  journal  entry  form  these  entries  will  appear  as 
follows : 

Interest  on  Bonds $1,250.00 

Cash    $1,250.00 

To  pay  the  nominal  interest  at  the  rate  of  5%  on  the  par  value  of  bonds 
outstanding 

Premium   on   Bonds 500.00 

Interest  on  Bonds 500.00 

To  credit  yearly  installment  of  bond  premiums  to  Interest  Account 


Liabilities  209 

The  account,  Interest  on  Bonds,  shows,  on  the  debit 
side,  interest  actually  paid  in  cash  and,  on  the  credit  side, 
the  yearly  installment  of  the  deferred  liability,  Premium 
on  Bonds.  The  difference  between  the  two  sides  repre- 
sents the  real  or  effective  interest. 

Considering  these  discounts  and  premiums  as  deferred 
charges  and  credits  to  the  nominal  account,  Interest  on 
Bonds,  renders  it  easy  to  see  that  when  bonds  are  issued 
at  less  than  par,  the  discount  represents  neither  an 
immediate  loss  nor  a  charge  to  permanent  asset  accounts. 
When  bonds  are  sold  above  par,  the  premium  does  not 
represent  an  immediate  profit,  and  it  is  clearly  improper 
to  credit  it  either  to  Surplus  or  to  Profit  and  Loss. 

In  the  past  certain  corporations  have  treated  bond 
discount  as  similar  to  organization  expense,  merging  it 
with  one  of  the  fixed  asset  accounts.  Under  the  proper 
theory  of  bond  discounts  this  procedure  is  self -evidently 
vicious.  It  tells  two  falsehoods — it  falsely  inflates  the 
value  of  the  fixed  assets,  and  it  fails  to  tell  the  truth 
about  the  real  cost  of  financing. 

In  the  past  it  has  not  been  unusual  to  treat  premiums 
realized  on  bond  sales  as  immediate  profits,  crediting 
them  either  to  Profit  and  Loss  or  to  Surplus.  In  the 
light  of  the  fundamental  theory  of  bond  premiums  it  is 
clear  that  such  procedure  is  absolutely  wrong.  It  results 
in  a  misstatement  of  profits  or  net  worth  and  a  misrep- 
resentation as  to  the  actual  cost  of  financing. 

There  are  several  methods  of  handling  bond  premiums 
and  discounts  which  vary  according  to  the  terms  of  the 
bond  itself,  i.  e.,  as  to  its  redemption.  It  is  very  often 
provided  that  the  concern  issuing  the  bonds  must  redeem 
a  certain  number  of  them  each  year  either  at  current 
market  price  or  at  a  fixed  amount  above  par.  Thus  a 
twenty-year  $1,000.00  bond  may  contain  the  provision 


210 


Principles  of  Accounting 


that  it  is  redeemable  or  callable  in  ten  years  at  105.  This 
means  that  the  holder  of  the  bond  must  surrender  it  for 
$1,050.00  at  any  time  after  ten  years  if  he  is  called  upon 
to  do  so.  If,  however,  the  corporation  can  buy  its  own 
bonds  in  the  open  market  for  less  than  $1,050.00,  it  will 
do  so.  Assuming  that  a  reserve  has  been  built  up  for 
the  purpose  of  buying  back  bonds  at  105,  you  will  find 
that  each  purchase  in  the  market  at  a  less  price  will  result 
in  a  profit  which  may  very  properly  be  credited  to  the 
Interest  Account.  The  accounting  treatment  of  redeem- 
able and  convertible  bond  issues  need  not  be  elaborated 
here.  Eeaders  who  are  interested  in  this  branch  of 
accounting  will  find  an  excellent  treatise  on  the  subject 
written  by  Charles  E.  Sprague  entitled,  The  Accountancy 
of  Investment.  This  volume  can  be  obtained  at  almost 
any  good  public  library. 

Only  one  further  point  need  be  considered  in  connection 
with  bonded  indebtedness.  Bonds  which  have  been  re- 
purchased may  be  either  held  alive  in  the  treasury  or 
cancelled.  If  the  former  course  is  adopted,  they  will 
appear  on  the  balance  sheets  as  assets,  although  many 
accountants  favor  showing  them  in  an  inside  column  as 
deductions  from  the  total  bonded  indebtedness,  extending 
only  the  net  amount  of  outstanding  bonds  into  the  liability 
column. 

BALANCE  SHEET 


All  Assets $62,000.00 


$62,000.00 


Accounts  Payable $  3,000.00 

Total  Bonds... $40,000.00 
Less — Bonds  in 

Treasury  . . .     8,000.00 


Outstanding  Bonds 32,000.00 

Capital  &  Surplus 27,000.00 


$62,000.00 


Liabilities  211 

If  the  bonds  are  cancelled  after  having  been  repurchased, 
they  should  no  longer  appear  on  the  books.  The  Bond 
Account  should  be  debited,  and  Treasury  Bonds  should 
be  credited  for  the  par  value  of  the  cancelled  bonds. 

Apparently  the  best  practice  is  to  reserve  the  term 
"treasury  bonds "  for  bonds  that  have  been  reacquired 
either  through  purchase  or  through  gift.  Bonds  which 
have  never  been  issued  may,  if  desired,  be  recorded  in  an 
account  entitled  "Unissued  Bonds, "  but  on  the  balance 
sheet  they  should  not  appear  as  an  asset  but  as  a  deduc- 
tion from  the  total  amount  of  authorized  bonds  on  the 
liability  side,  since  the  best  authorities  do  not  consider 
unissued  bonds  a  real  asset. 

TEST  QUESTIONS 

1.  What  are  current  liabilities? 

2.  What  is  the  nature  of  accrued  liabilities? 

3.  What  is  the  best  way  to  treat  notes  receivable  discounted? 

4.  What  is  a  bond? 

5.  (a)  What  is  the  nature  of  premium  on  bonds? 
(b)  What  is  the  nature  of  discounts  on  bonds? 

6.  Are  unissued  bonds  a  real  asset  ? 


CHAPTER  VH 

PROPRIETORSHIP 

The  primary  classification  of  accounts  is  into  two  sub- 
divisions— real  and  nominal.  Real  accounts  are  the  asset 
and  liability  accounts.  Nominal  accounts  are  the  proprie- 
torship accounts. 

When  a  business  is  created,  a  proprietorship  account 
is  also  created.  For  the  net  worth  with  which  the  pro- 
prietor started  in  business,  represented  by  the  difference 
between  the  assets  and  liabilities,  a  credit  is  set  up  in  his 
account.  As  expenses  are  incurred,  losses  suffered,  and 
profits  earned,  appropriate  debits  and  credits  may  con- 
ceivably be  made  daily  to  the  original  Proprietor's 
Account.  With  such  a  simple  system  it  would  be  possible 
to  determine  the  relation  between  the  proprietor  and  his 
business  at  any  time  by  glancing  at  the  balance  of  his 
account.  To  determine  the  profit  or  loss  during  a  given 
period,  a  comparison  could  be  made  of  successive  balance 
sheets.  Thus,  if  one  balance  sheet  showed  a  net  proprie- 
torship credit  of  $1,000.00  and  the  one  of  a  year  later 
indicates  $1,200.00  as  being  due  the  proprietor,  it  is  clear 
that  the  condition  of  the  business  has  improved  by 
$200.00. 

MIXED  ELEMENTS  OF  PROPRIETORSHIP 

Just  how  valuable  is  this  information?  It  has  very 
little  value  unless  certain  other  facts  are  known,  namely, 
the  proprietor's  withdrawals  or  additional  investments 
during  the  year.  The  profit  from  operation  might  have 
been  $500.00  and  the  withdrawals  $300.00,  or  the  loss  from 

212 


Proprietorship  213 

operations  might  have  been  $100.00  and  the  additional 
investment  $300.00.  Each  period  the  balance  of  the 
account  represents  the  net  investment,  distinguishing  in 
no  manner  between  the  original  investment  of  capital, 
subsequent  investments  or  withdrawals,  and  operating 
surplus  or  deficit. 

In  order  to  determine  the  profit  or  loss  of  a  given 
period  something  more  than  comparative  balance  sheets 
is  needed.  A  balance  sheet  shows  the  condition  of  a 
business  at  a  given  moment  of  time,  but  it  gives  no  in- 
formation as  to  the  causes  leading  up  to  that  condition. 
Since  every  transaction  resulting  in  a  loss  or  a  gain 
results  ultimately  in  a  debit  or  credit  to  the  Proprietor's 
Account,  an  analysis  of  that  account  will  supply  the  miss- 
ing information.  Such  an  analysis,  in  proper  form,  is 
known  as  a  "profit  and  loss  statement. "  *  In  its  most 
primitive  form  it  is  a  list  of  the  various  proprietorship 
credits  and  debits  made  during  a  given  accounting  period, 
the  difference  between  the  total  debits  and  the  total  credits 
being  the  profit  or  loss.  A  better  form  of  statement 
would  not  list  all  the  items,  but  would  eliminate  those 
referring  to  withdrawals  and  investments.  In  order  to 
do  this  easily  the  single  original  Proprietor's  Account 
may  be  replaced  by  four  main  proprietorship  accounts. 

1.  Capital  Investment  Account. 

2.  Surplus  or  Deficit  Account. 

3.  Profit  and  Loss  Allocation  Account. 

4.  Profit  and  Loss  Account. 

The  Profit  and  Loss  Account  must  not  be  confused  with 
the  profit  and  loss  statement,  since  the  former  is  a  general 

i  Also  spoken  of  as  an  income  statement,  a  revenue  statement,  or  a  loss 
and  gain  statement.  Owing  to  the  unsatisfactory  condition  of  accounting 
terminology,  these  names  are  used  interchangeably  and  indiscriminately. 


214  Principles  of  Accounting 

ledger  account  and  the  latter  a  schedule  or  exhibit.  To 
the  Profit  and  Loss  Account  is  credited  the  income  of  the 
period,  and  it  is  charged  with  the  operating  expenses  of 
the  period.  The  balance  of  the  account  is  the  net 
operating  profit  (or  loss),  which  is  transferred  to  the 
Profit  and  Loss  Allocation  Account.  This  account  is 
debited  with  all  the  current  profits  taken  from  the  busi- 
ness by  the  proprietor.  Its  balance  represents  the  profits 
which  are  to  remain  in  the  business,  and  is  transferred 


FIG.  51. — Chart  Showing  Primary  Subdivision  of  Proprietorship 

to  the  Surplus  Account  as  an  additional  investment.  If 
this  figure  should  represent  a  loss,  it  would  be  carried 
to  the  Surplus  Account  as  a  debit,  representing  a  reduc- 
tion in  the  investment.  Should  it  happen  that  the  Sur- 
plus Account  had  no  credit  balance,  the  loss  would  be 
charged  to  the  Deficit  Account. 

The  Capital  Account  represents  the  investment  and  is 
credited  with  the  original  and  all  subsequent  investments 
in  the  business.  It  may  be  debited  with  all  withdrawals 
of  capital  (not  of  profits). 

Under  such  an  arrangement  (Figure  51)  the  profit  and 


Proprietorship  215 

loss  statement  may  be  constructed  from  the  Profit  and 
Loss  Account,  since  this  account  represents  the  income 
and  costs  of  the  accounting  period,  other  factors,  such  as 
withdrawals  of  profits,  not  being  included.  It  is  clear 
that  the  total  net  profit  is  the  significant  figure,  not  the 
net  profit  less  withdrawals. 

PROPRIETORSHIP  ENTRIES 

If  it  is  assumed  that  all  proprietorship  debits  and 
credits  are  made  direct  to  one  of  these  four  accounts, 
the  question  which  will  immediately  arise  in  any  particu- 
lar case  is,  "  which  one  shall  receive  the  entry  1"  Losses 
may  be  roughly  divided  into  two  classes — capital  losses 
such  as  are  caused  by  the  destruction  of  property  by  fire, 
hurricane,  flood,  etc.,  and  current  expenses  which  are 
incurred  for  the  purpose  of  obtaining  an  increased  income 
at  a  later  time,  such  as  salaries  paid  to  salesmen,  rent, 
etc.  It  is  clear  that  these  two  classes  of  loss  should  not 
be  confused.  The  loss  of  a  capital  asset  is  a  misfortune, 
but  it  does  not  necessarily  indicate  operating  inefficiency. 
If,  however,  current  operating  expenses  are  high  as  com- 
pared with  current  operating  income,  inefficiency  may  be 
the  cause. 

There  is  no  difference  between  the  dollar  which  comes 
into  the  business  as  the  result  of  the  sale  of  merchandise 
and  the  dollar  which  results  from  the  sale  of  a  fixed 
asset,  but  careful  distinction  must  be  made  between  these 
two  classes  of  income.  The  first  is  normal,  and  the  second 
is  abnormal.  To  lump  them  together  would  obscure 
results  and  make  it  impossible  to  compare  the  statements 
of  different  accounting  periods.  If,  therefore,  we  restrict 
the  Profit  and  Loss  Account  to  the  booking  of  current 
expenses  and  income  only,  the  profit  and  loss  statements 
which  are  prepared  from  such  accounts  can  be  com- 


216  Principles  of  Accounting 

pared  for  successive  accounting  periods.  Extraordinary 
profits,  not  applicable  to  any  particular  accounting  period 
such  as  might  arise  from  the  sale  of  fixed  assets,  should 
not  be  credited  to  the  Profit  and  Loss  Account  at  all,  but 
should  go  direct  to  the  Surplus  Account.  All  expense 
which  is  actually  applicable  to  the  accounting  period  may 
be  debited  to  the  Profit  and  Loss  Account,  but  extraor- 
dinary losses  not  consequent  upon  operation  and  not 
applicable  to  any  particular  period  such  as  losses  by  fire, 
flood,  shipwreck,  or  war,  should  be  debited  to  the  Surplus 
Account.  Such  extraordinary  losses  and  gains  may  be 
infrequent,  but  because  of  their  infrequency  it  would  be 
wrong  to  lump  them  with  the  operating  profits  and  losses 
for  the  period.  This  distinction  between  capital  profits 
and  losses  and  current  profits  and  losses  must  be  care- 
fully observed,  otherwise  no  enlightening  information 
can  be  obtained  from  a  comparison  of  results  for 
successive  accounting  periods. 

SUBSIDIAKY  ACCOUNTS 

To  analyze  the  Profit  and  Loss  Account  is  a  wasteful 
and  unnecessary  procedure.  The  daily  changes  in  pro- 
prietorship may  be  entered  in  temporary  subsidiary 
proprietorship  accounts.  At  the  end  of  each  accounting 
period  these  accounts  will  be  closed  into  Profit  and  Loss. 
Thus,  instead  of  debiting  rent  to  the  Profit  and  Loss 
Account  whenever  rent  is  paid,  it  may  be  debited  to  a 
Kent  Account,  wages  may  be  debited  to  a  Wages  Account, 
salaries  to  a  Salaries  Account,  heat  and  light  to  a  Heat 
and  Light  Account,  etc. 

It  is  when  such  classified  expense  and  income  accounts 
are  kept  that  there  is  no  need  for  analysis.  The  balances 
of  these  accounts  may  be  used  in  constructing  the  profit 
and  loss  statement  and,  at  the  end  of  the  accounting 


Proprietorship  217 

period,  transferred  by  means  of  closing  journal  entries 
to  Profit  and  Loss,  which  is  now  only  a  summary  account. 
The  balance  of  that  account  represents  the  net  profit  (or 
loss)  for  the  period.  This  figure  may  then  be  transferred 
to  the  Profit  and  Loss  Allocation  Account,  offsetting  any 
debit  entries  contained  therein  due  to  premature  with- 
drawal of  profits.  The  balance  of  the  Profit  and  Loss 
Allocation  Account  then  represents  the  amount  which  may 
be  transferred  to  the  Surplus  or  Deficit  Account. 

THREE  CLASSES  OF  PROPRIETORSHIP 

With  this  skeleton  plan  of  classification  in  mind  various 
forms  of  proprietorship  may  be  discussed.  There  are 
three  common  forms: 

1.  The  sole  proprietor. 

2.  Co-partners. 

3.  Stockholders. 

SOLE  PROPRIETORSHIP 

Sole  proprietorship  is  very  common  in  the  small  busi- 
ness. The  fruit  peddler,  the  bootblack,  and  the  cobbler 
may  be  examples  of  sole  proprietors.  Nearly  all  small 
grocery  stores  and  butcher  shops  have  but  a  single  owner. 

PARTNERSHIP 

The  somewhat  larger  business  is  more  commonly  a 
partnership,  involving  two  or  more  proprietors.  In- 
sufficient funds  often  lead  the  sole  proprietor  to  take 
another  individual  to  share  gains  and  losses  with  him. 
Frequently  the  partners  have  an  equal  investment  in  the 
business  and  share  all  profits  and  losses  equally.  Some- 
times their  investments  are  unequal,  and  profits  and 
losses  are  divided  upon  an  agreed  basis. 


218  Principles  of  Accounting 

"Partnership"  has  been  defined  as  "the  contract 
relation  subsisting  between  persons  who  have  combined 
their  property,  labor,  or  skill  in  an  enterprise  or  business 
as  principles,  for  the  purpose  of  a  joint  profit." 

A  partnership  ordinarily  has  the  following  elements: 

1.  It  is  a  relation  created  by  the  agreement  of  the 
parties,  not  by  law. 

2.  Ordinarily  each  member  contributes  to  the  establish- 
ment of  a  common  fund. 

3.  It  has  in  view  the  carrying-on  of  some  lawful  busi- 
ness. 

4.  Its  purpose  is  the  profit  of  the  associates. 

5.  Each  partner  has  the  implied  power  to  bind  all  other 
members  within  the  scope  of  the  business. 

6.  It  holds  a  joint  liability  to  outside  parties  for  all 
debts  and  contracts  of  the  firm.     This  means  that 
any  partner  may  be  forced  to  pay  the  whole  debt  of  a 
firm  out  of  his  private  means. 

Some  very  interesting  accounting  problems  arise  in 
connection  with  partnership,  but  these  will  be  discussed 
in  a  later  chapter.  The  proper  accounting  procedure  in 
connection  with  a  partnership  is  to  open  separate  capital, 
surplus,  and  drawing  accounts  for  each  partner.  The 
net  profit  or  net  loss  at  the  end  of  each  accounting  period 
is  credited  or  debited  to  the  Profit  and  Loss  Allocation 
Account  and  from  there  transferred  to  the  partners' 
drawing  accounts  in  accordance  with  an  agreed-upon 
ratio.2 

2  In  reality  partnership  accounting  is  not  on  a  truly  scientific  basin. 
While  accountants  agree  as  to  the  desirability  of  keeping  the  investment 
•eparate  from  accumulated  profits  and  losses  due  to  operation,  it  is  found 
that,  in  actual  practice,  nearly  all  partnerships  omit  the  Profit  and  Loss 
Allocation  Account,  transferring  the  net  profit  for  the  period  direct  from 
the  Profit  and  Loss  Account  to  the  partners '  drawing  accounts.  The  unwith- 


Proprietorship  219 

In  forming  a  partnership  it  is  usual  to  draw  up  an 
agreement,  which  is  commonly  known  as  the  ' t  articles  of 
partnership. "  A  clause  is  usually  incorporated  in  this 
document,  stating  how  the  partners  shall  share  losses 
and  gains.  When  no  such  agreement  is  in  existence  or 
where  it  does  not  state  the  ratio  in  which  the  partners 
shall  divide  losses  and  gains,  it  is  a  rule  of  law  that  they 
shall  be  divided  equally  among  all  the  partners,  regardless 
of  the  capital  invested. 

COKPORATIONS 

"A  corporation  is  an  artificial  being,  invisible,  in- 
tangible, and  existing  only  in  contemplation  of  the 
law."3  It  is  composed  of  persons  who  are  known  as 
' '  stockholders. "  The  interest  of  the  stockholders  is 
regarded  as  divided  into  equal  shares,  called  "shares  of 
stock. ' '  When  a  person  purchases,  or  otherwise  acquires, 
an  interest  in  the  capital  stock,  he  is  spoken  of  as  owning 
a  certain  number  of  shares  of  stock.  These  stockholders, 
however,  are  not  the  corporation.  A  corporation  has  a 
name,  an  individuality,  and  an  existence  apart  and  distinct 
from  its  stockholders.  It  may  conduct  business,  bring 
actions  at  law,  or  make  contracts.  A  corporation  carries 
on  its  business  through  officers  and  agents,  and  it  may 
even  enter  into  contracts  with  its  stockholders  and  sue 
them  and  be  sued  by  them  just  as  any  individual. 

Corporation  accounting  represents  the  most  advanced 
type  known.  A  corporation  usually  conducts  a  much 

drawn  portions  are  then  transferred  to  the  partners'  capital  accounts.  For 
convenience  in  presenting  the  subject  of  proprietorship,  it  will  be  assumed 
that  proposed  classification  is  actually  in  common  use.  In  Chapter  IX  the 
subject  of  partnership  will  be  more  fully  discussed  and  actual  procedure 
explained. 

s  The  definition  of  Chief  Justice  Marshall  in  the  case  of  the  Trustees 
of  Dartmouth  College  v.  Woodward. 


220  Principles  of  Accounting 

more  extensive  business  than  a  sole  proprietor  or  a 
partnership.  It  controls  larger  amounts  of  capital,  and 
its  business  is  more  complex.  All  these  things  affect  the 
accounting  system.  Some  of  the  special  problems  con- 
nected with  corporation  accounting  will  be  treated  in 
Chapter  X. 

CORPORATION  PROPRIETORSHIP 

In  the  corporation,  there  may  be  a  number  of  main  pro- 
prietary acounts.  The  principal  one  is,  of  course,  Capi- 
tal Stock.  This  account  is  credited  with  the  par  value  of 
all  shares  of  stock  issued.  Its  debits,  if  there  be  any, 
are  caused  by  the  cancellation  of  stock.  Its  balance, 
therefore,  represents  the  total  number  of  shares  of  stock 
outstanding  expressed  in  terms  of  money,  since  each  share 
of  stock  has  a  par  value,4  usually  $100.00. 

It  is  clear  that  a  distinction  should  be  made  between 
capital  stock  and  capital.  The  capital  is  the  sum  total  of 
assets  owned  by  the  corporation.  The  capital  stock  rep- 
resents the  interest  which  the  stockholders  have  in  those 
assets.  The  capital  stock  remains  as  fixed  by  legislative 
sanction,  while  we  have  already  seen  that  the  value  of 
assets  changes  due  to  appreciation,  depreciation,  profits, 
and  losses.  The  capital  of  the  corporation  and  the  capi- 
tal stock  of  the  corporation  may  be,  and  usually  are,  rep- 
resented by  very  different  figures. 

The  net  capital  of  the  corporation,  i.  e.,  the  total  assets 
less  the  total  outside  liabilities,  equals  the  proprietary 
interest.  The  proprietary  interest  may  be  greater  or 
less  than  the  capital  stock,  although  at  the  beginning  of 
business  it  would  ordinarily  be  equal  to  the  capital  stock. 
As  time  goes  on,  however,  profits  may  be  made,  and  if 

*  This  is  a  matter  of  statutes,  and  some  of  the  states,  notably  New  York, 
permit  the  issue  of  stock  without  par  value. 


Proprietorship  221 

they  are  not  all  withdrawn,  they  serve  to  increase  the 
proprietary  interest.  They  cannot  be  credited  direct  to 
the  Capital  Stock  Account,  since  it  is  fixed  in  amount. 
Another  proprietary  account  is,  therefore,  provided  for 
that  purpose.  This  is  known  as  the  "Surplus  Account/' 
and  according  to  best  usage  it  includes  only  undivided 
profits  which  may  be  declared  as  dividends. 

If  the  venture  proves  to  be  a  disastrous  one  and  sur- 
plus having  been  exhausted,  losses  are  greater  than 
profits,  they  should  be  debited  to  a  Deficit  Account,  the 
balance  of  which  will  appear  on  the  left-hand  or  debit 
side  of  the  trial  balance.  It  is  not  an  asset  but  a  negative 
surplus  account,  explaining  the  difference  between  the 
assets  and  the  sum  of  the  liabilities  plus  investment,  and 
it  must  be  taken  into  combination  with  the  other  proprie- 
torship accounts  to  determine  the  net  worth  of  the  corpo- 
ration. Practically  never  is  the  net  worth  of  the  cor- 
poration equal  to  the  balance  of  the  Capital  Stock 
Account;  therefore  nearly  every  corporation  carries 
either  a  Surplus  or  a  Deficit  Account  on  its  books.  In 
addition  to  these  accounts,  there  may  be  other  proprie- 
tary accounts,  such  as  Undivided  Profits  or  Reserves. 
Undivided  profits,  as  the  name  implies,  represent  profits 
which  have  not  yet  been  distributed.  Undivided  profits 
may  be  paid  out  as  dividends,  may  be  reserved  for  con- 
tingencies, or  may  be  credited  to  Surplus. 

A  reserve  is  surplus  appropriated  for  a  specific  pur- 
pose. It  is  often  desirable  to  "  earmark "  a  certain  por- 
tion of  the  surplus  in  order  that  it  may  not  appear 
available  for  dividends.  Such  reserves  are  usually  "set 
up"  to  care  for  contingencies,  such  as  possible  losses 
from  bad  debts  or  accidents,  such  as  floods,  fires,  or  ship- 
wrecks. 


222  Principles  of  Accounting 

CLASSIFICATION  OF  NOMINAL  ACCOUNTS 

Every  trading  business  has  for  its  fundamental  func- 
tion the  acquisition  of  goods  at  one  price,  having  in  con- 
templation the  object  of  selling  at  a  greater  price.  If  a 
business  could  be  run  without  any  expense,  its  profit  for 
any  period  would  be  equal  to  the  difference  between  the 
total  sales  of  merchandise  during  the  period  and  the 
total  purchase  cost  of  the  goods  that  were  sold.  No  busi- 
ness ever  does  operate  without  expense ;  hence  the  selling 
price  of  merchandise  must  be  sufficient  to  pay  for  the 
goods,  to  pay  for  the  expense  incurred  in  operating  and 
selling,  and  still  leave  a  profit.  If  at  the  end  of  an 
accounting  period  it  is  discovered  that  no  operation  profit 
has  been  made,  there  may  be  two  reasons ;  i.  e.,  either  the 
goods  cost  more  than  they  could  be  sold  for  or  the  ex- 
penses of  the  business  are  too  high  or  both.  For  that 
reason  it  is  desirable  to  show  on  the  profit  and  loss  state- 
ment separate  tables  for 

1.  Trading  activities. 

2.  Expenses. 

That  section  of  the  profit  and  loss  statement  which 
reflects  the  trading  activities  is  known  as  the  "trading 
statement."  The  fundamental  structure  of  the  exhibit 
is  simple,  consisting  of : 

Sales  minus  cost  of  sales  equals  gross  trading  profit. 

The  cost  of  sales,  or  the  cost  of  goods  sold,  is  arrived 
at  by  adding  the  purchases  of  merchandise  during  the 
accounting  period  to  the  inventory  of  merchandise  at 
the  beginning  of  the  period  and  from  the  total  thus  ob- 
tained, deducting  the  inventory  at  the  end  of  the  period. 
The  gross  profit  furnished  by  the  trading  statement  is 


Proprietorship  223 

the  profit  before  the  expenses  of  the  business  have  been 
considered.  It  is  a  figure  which  means  very  little,  since 
it  only  expresses  the  relation  between  sales  and  cost  of 
sales.  According  to  the  strict  meaning  of  the  word 
"profit,"  its  title  is  a  misnomer,  but  since  it  is  in  common 
use,  we  may  adopt  it  here. 

Total    Sales $ 

Inventory  beginning  of  period $ 

Purchases  during  period 


Deduct — Inventory  end  of  period 

Cost  of  Goods  Sold 

Gross  Profit $ 

The  first  section  of  any  profit  and  loss  statement  is, 
therefore,  one  which  gives  the  gross  profit,  and  from  this 
figure  must  be  deducted  the  expenses,  the  result  being 
the  net  operating  profit.  It  is  clear  that  this  may  not  be 
the  total  net  profit  of  the  business  as  a  whole,  since  there 
may  be  other  forms  of  income  than  that  derived  from  the 
sale  of  goods.  Interest  may  be  received,  and  purchase 
discounts  may  be  taken.  These  are  both  items  of  income, 
strictly  connected  with  the  business,  which  cannot  be 
classified  as  income  from  sales.  Therefore,  to  the  net 
operating  profit  (or  prime  operating  profit)  is  added  the 
other  income,  and  from  the  resulting  total  is  deducted 
the  sundry  income  charges,  such  as  interest  paid,  sales 
discounts  allowed,  etc.  These  are  items  which  must  be 
taken  into  consideration  before  the  net  profit  for  the 
period  can  be  obtained,  and  yet  they  cannot  be  classified 
as  either  selling,  administration,  or  general  expenses. 
They  are  often  referred  to  as  financial  items. 


224  Principles  of  Accounting 


. 


EXPENSE  CLASSIFICATION 


The  expenses  may  be  classified  by  the  objects  of  ex- 
penditure, one  group  of  expense  accounts  being  used  for 
the  business  as  a  whole.  Such  a  method  of  classifying 
expenses  might  yield  the  following  subaccounts : 

Salaries. 

Wages. 

Supplies  Used. 

Heat  and  Light. 

Rent. 

Depreciation  of  Equipment. 

Sundry  Expenses. 

The  chart  shown  in  Figure  52  illustrates  graphically 
the  system  of  proprietorship  accounts  classified  accord- 
ing to  such  a  plan. 

The  defects  of  this  sort  of  classification  are  obvious. 
Efficiency  in  operation  cannot  be  obtained  when  the  ac- 
counts are  classified  only  according  to  objects  of  expendi- 
ture, neglecting  the  various  departmental  lines.  The 
manager  wishes  to  know  the  reasons  for  high  or  low 
expenses.  He  wants  to  give  credit  to  the  departmental 
manager  who  operates  on  minimum  expense  and  to  cen- 
sure that  one  whose  expenses  are  too  high. 

Nearly  every  business  is  made  up  of  certain  broad 
functions.  Thus,  in  the  ordinary  trading  concern  the 
purely  merchandise  operations  are  recorded  in  the  Trad- 
ing Account,  and  the  expenses  naturally  classify  them- 
selves under  the  three  heads  of 

1.  Selling. 

2.  Administration. 

3.  General. 


Proprietorship 


225 


FIG.  52. — Chart  Showing  Classification  of  Expense  Accounts  According  to 
Objects  of  Expenditure 


226  Principles  of  Accounting 

As  subaccounts  to  Selling  Expense,  the  following 
might  appear : 

Salaries  of  Salesmen. 

Expenses  of  Salesmen. 

Advertising  Purchased. 

Shipping  Expenses. 

Telephone,  Telegraph,  and  Postage. 

Heat  and  Light  for  Salesroom. 

Depreciation  of  Sales  Office  Equipment. 

Miscellaneous  Sales  Expense. 

Administration  Expenses  include  all  the  costs  of  admin- 
istration, such  as 

Salaries  of  Officers. 

Salaries  of  Clerical  Help. 

Office  Supplies  Used. 

Telephone,  Telegraph,  and  Postage. 

Heat  and  Light  of  Office. 

Depreciation  of  Office  Equipment. 

Miscellaneous  Expense. 

> 

Under  the  heading  of  General  Expense  are  included 
the  various  items  which  cannot  be  classified  as  items  of 
either  sales  or  administration. 

Such  a  classification  of  expense  accounts  as  this  is 
illustrated  in  Figure  53.  Under  this  scheme  it  will  be 
seen  that  the  expense  accounts  assume  a  somewhat  differ- 
ent function  from  that  which  they  assumed  when  the 
classification  was  only  by  objects  of  expenditure.  The 
total  selling  cost  as  distinguished  from  the  administra- 
tion expense  may  be  obtained  by  properly  grouping  the 
several  subaccounts.  The  general  scheme  of  classified 
expense  accounts  having  been  developed,  the  funda- 


Proprietorship 


227 


FIG.  53. — Chart  Showing  Common  Classification  of  Expense  Accounts 


228  Principles  of  Accounting 

mental  construction  of  the  profit  and  loss  statement  may 
be  considered. 

PKOFIT  AND  Loss  STATEMENT 

When  a  trial  balance  is  taken  from  the  General  Ledger, 
the  balances  of  all  the  classified  expense  accounts  appear 

SK2LBTOH  OP  TRADIUO  AHD  PBOFIT  AHD  LOSS  STATEMENT 
Trading 

Sales  during  period  *-.. 

Inventory  beginning  of  period  $ ... 

Purchases  during  period  ...  .. 

$— .-- 
Deduct- Inventory  end  of  period  ...... 

Coat  of  goods  sold  during  period 

Gross  profit  for  period  $ ... 

Expenses 

Selling  Costs  of  perlot  $.*.... 

Administration  Costs  of  psriod  ...... 

Total  "Selling  and  Administration  Costs  _mi~T_ 

Prime  Operating  Profit  $ — ... 

Financial 

Other  Income  of  period  .._  .. 


Charges  to  Income  of  period 

Bet  Profit  for  period  $ ... 

FIG.  54. — Model  Statement  Form 

thereon  and  are  used  as  a  basis  for  the  construction  of 
the  profit  and  loss  statement.  We  have  seen  that  the 
Profit  and  Loss  Account  may  have  three  subaccounts,  viz. : 


Proprietorship  229 

Trading  Account. 
Operating  Expense  Account. 
Financial  Expense  and  Income  Account. 

It  is  natural,  therefore,  that  the  profit  and  loss  state- 
ment should  follow  these  general  divisional  lines:  the 
first  section  of  the  profit  and  loss  statement,  consisting 
of  the  trading  items,  the  second  section  of  the  operating 
expense,  and  the  third  section  of  the  financial  income  and 
expense  items. 

The  skeleton  form  of  a  profit  and  loss  statement  such 
as  has  been  explained  in  the  foregoing  paragraphs  is 
given  in  Figure  54.  For  the  present  this  may  be  re- 
garded as  a  standard  form,  since  all  profit  and  loss  state- 
ments are  based  upon  this  fundamental  plan. 

Sales  during  the  period  are  the  net  sales  after  all  re- 
turns of  merchandise  by  customers  have  been  deducted. 
It  is  sometimes  desirable  to  show  the  gross  sales  for  the 
period  and  the  net  sales  in  order  that  the  amount  of  cus- 
tomers '  returns  may  be  compared  for  consecutive  periods. 
As  a  subaccount  to  the  Trading  Account  there  may  be 
carried  a  Returned  Sales  Account.  Instead  of  charging 
Sales  and  crediting  Accounts  Receivable  for  returned 
goods,  the  entry  may  be 

Keturned    Sales $ 

Accounts    Receivable $ 

For  merchandise  returned 
by  customers 

On  the  trading  statement  the  balance  of  returned  sales 
will  be  deducted  from  gross  sales  to  obtain  the  figure  rep- 
resenting net  sales. 

Guided  by  the  skeleton  form  of  the  profit  and  loss  state- 
ment in  Figure  54,  we  may  construct  a  model  profit  and 


230 


Principles  of  Accounting 


loss  statement  (Figure  55)  in  detail  form  from  the  follow- 
ing trial  balance  accounts : 

SECTION  OF  BLANK  COMPANY'S  TRIAL  BALANCE 
DECEMBER  31,  191 — 

Debit  Credit 

Total  Sales $133,300.00 

Returned   Sales  and  Allowances $      200.00 

Purchases    73,000.00 

Inventory  of  Merchandise,  Jan.   1,  191 — 15,000.00 

Salaries — Sales    Dept 7,000.00 

"          Advertising   Dept ...  4,800.00 

"          General    Office 11,500.00 

Traveling  Expense — Sales  Dept 3,000.00 

Telephone,  Telegrams,  and  Postage — Sales  Dept 700.00 

Telephone,     Telegrams,     and     Postage — Advertising 

Dept    450.00 

Telephone,  Telegrams,  and  Postage — General  Office..  1,500.00 

Depreciation — Sales  Office  Equipment 200.00 

' *              Advertising  Office  Equipment. ... 350.00 

"              General  Office  Equipment 500.00 

Shipping  Expense 1,500.00 

Light  and  Heat— Sales  Dept 700.00 

"       "       "        Advertising    Dept 500.00 

"       "       "        General    Office ;...  2,500.00 

Miscellaneous  Sales  Dept.  Expense 500.00 

' '             Advertising  Dept.  Expense 300.00 

' '             General    Office 1,500.00 

Advertising    Purchased 10,000.00 

Supplies  Used— General  Office 2,500.00 

Purchase  Discounts 200.00 

Interest  Received 300.00 

Miscellaneous    Income 100.00 

Insurance    800.00 

Taxes  700.00 

Interest  Paid 100.00 

Sales  Discounts 200.00 

Bad  Debts 300.00 

Surplus   Adjustment    Account 1,800.00 

Surplus,  Jan.  1,  191—. 85,000.00 


Note.— The  Merchandise  Inventory  Dec.  31,  191—,  equals  $14,000.00. 


Proprietorship  231 


MODEL 

ttCOIIE  AHD  PROFIT  AMD  LOSS  STATEMBHT  ~  BLABZ  COJIPAIY 
Year  Ending  December  31,  191_ 


Tradlag 

Total  Sales  ...................  ..........................  $133,500.00 

Deduct—Returned  Sales  and  Allowance*  .  »  .................     200.00 

Gross  Income  ........................................  ............  $133  ,  100  .00 

Inventory  of  Merchandise,  Jan.l,191_  ......................  $15,000.00 

Purchases  during  period  ...........  7  ...............  .  .....  .-73.000.00 


Deduct  —  Inventory  of  Merchandise,  Dec.  31,  191  14_.OOO.OQ 

Cost  of  Goods  Sold  .....  ...............  77  ........................ 

Gross  Profit  .  ........................  ...  ...................  ?  59,100.00 

Selling  Costs 

Salaries  ........................................  $  7,000.00 

Traveling  Expense  ................................  3,000.00 

Telephones,  Telegrams,  and  Postage  ...............   700.00 

Depreciation—Sales  Office  Equipment  .......  ......   200.00 

Shipping  Expense  ............................  .....  1,500.00 

Light  and  Heat--Sales  ............................   700.00 

Miscellaneous—Sales  .............................   500.00 

Aivertising  Purchased  ............................  10,000.00 

Advertising  Dept.  Salaries  .......................  4,800.00 

Advertising  —  Telephones,  Telegrams,  and  Postage  ....   450.00 

Depreciation—  Advertising  Office  Equipment  .......   350.00 

Light  and  Heat-  -Advert!  sing  ......................   500.00 

Miscellaneous—  Advertising  .......................   500.00 

Total  Selling  Cost  .........................  ..........  $30,000.00- 

Administration  Costs 

Salaries—General  Office  .........................  $11  ,500.00 

Supplies—  General  Office  .........................  2,600.00 

Postage,  Telephones,  and  Telegrams—General  Office   1,500.00 

Light  and  Heat—  General  Office  ....................  2,500.00 

Depreciation—Office  Equipment  ....................   500.00 

Miscellaneous—  General  Office  Expense  .........  .  »  .  .  1  ,  500  .  00 

Total  Administration  Costs  ...........................  .20,000.00 

Total  Selling  and  Administration  Costa  .............................  50.000.00, 

Prime  Operating  Profit  .....................................  |  9,100.00 

Other  Income 

Purchase  Discounts  ............................................  $200.00 

Interest  Received  .............................................  300.00 

Mlstellaneous  .................................................  100.  PC 

Total  Other  Income  ................  ........  »...  ..........  600.00 

$9,700.00 

Charges  to  Income 

Sales  Discounts  ......................................  ,....,.  $200.00 

Interest  Paid  .............................................  .  .   100.00 

Insurance  ...............................  .....  .................   800.00 

Taxes  ...................................  ....................   700.00 

Bad  Debts  ...................................................   300.00 

Total  Charges  to  Income  ................................        -  2.100.00 

Net  Profit  for  Year  .......  .  ................................  .$7,600.00 

Surplus 

Balance  Sheet  Surplus,   Jan.  1,191   ...........  ................  $65,000.00 

Deduct—  Debit  Balance  of  Surplus~AdJuatment  Account  .........  .   1.800,00      ^  2QQ  ^ 

Balance  Sheet  Surplus,   De«.31,191_  ...............  ,-..i  ..................  .$90,800.00 

FIG.  55.  —  Statement  for  a  Merchandising  Organization 


232  Principles  of  Accounting 

It  will  be  noted  that  the  company  whose  profit  and 
loss  statement  is  given  in  Figure  55  purchases  all  the 
merchandise  which  it  later  resells  at  a  profit.  Let  us 

MODEL 

INCOME  AND  PROFIT  AM)  IOSS  STATEMENT— BLANK  COfflPAH* 
Year  Ending  Dec. 31,  191_ 

Trading 

Total  Sales |133 ,500.00 

Deduct --Re  turned  Sales  and  Allowances 200 .00 

Oroes  Income $133 , 100 .00 

Inventory  of  Merchandise,  Jan.l,  191   ., $  15,000.00 

Goods  Manufactured  during  period  ...7 75.000.00 

Deduct— Inventory  of  Merchandise,  Dec. 31,  191_ , 14 ! OOP.'" 


Cost  of  Goods  Sold  74.000.00 

OrosB  Profit  I 5ft.l66.66 

Selling  Coats 

Salaries  ~ f  7,000.00 

Traveling  Expense  

Telephones,  Telegrams,  and  Postage  

Depreciation—Sales  Office  Equipment  

Shipping  Expense  

Light  and  Heat—Sales  

Miscellaneous—Sales 

Advertising  Purchased 

Advertising  Dept .  Salaries  

Advertising—Telephones,  Telegrams , and  Postage 
Depreciation— Advertising  Office  Equipment  ... 

Mght  and  Heat—Advertising 

Miscellaneous—Advertising  

Total  Selling  Cost  777777777. f 30,000.00 

Administration  Costs 

Salaries—General  Office 

Supplies --General  Office 

Postage,  Telephones,  Telegrams --General  Office 

Light  and  Heat— General  Office  

Depreciation—Office  Equipment  

Miscellaneous  General  Office  Expense  

Total  Administration  Costs 20.000.00 

Total  Selling  and  Administration  Costs  ~  6Q.QOO.OO 

Prime  Operating  Profit $ 9,166.60 

Other  Income 

Purchase  Discounts ,.  $200.00 

Interest  Received 300.00 

Miscellaneous _100.00 

Total  Other  Income  "     ~     600.00 

$  9,700.00 


Charges  to  Income 

inv.  re  BV                                        • 

Surplus 

FIG.  56. — Statement  for  a  Manufacturing  Organization 
Compare  with   Fig.  55. 

suppose  that  instead  of  purchasing  the  goods  it  acquired 
the  factory  which  made  them.  The  two  organizations 
would  then  be  separate  units  under  one  ownership.  The 
factory  would  make  the  goods,  and  the  wholesale  house 


Proprietorship  233 

would  handle  them.  The  only  difference  that  would  nec- 
essarily be  made  in  the  profit  and  loss  statement  would 
be  to  change  the  trading  section,  eliminating  the  word 
" purchases "  and  substituting  " goods  manufactured." 
This  revised  statement  is  shown  in  Figure  56. 

MAITLTFACTURING  STATEMENT 

The  managers  and  owners  would,  doubtless,  be  inter- 
ested in  knowing  the  detailed  costs  of  producing  the 

Production  Coat* 

Inventory  of  Raw  Materials,   Jan. 1,191     $  9,000.00 

Purchases,   Including  In-Freight T. 41.OQO.oo 

f50.o6o.00 

Deduct-- Inventory,  Deo. 31,  191   10 .OOP. 00 

Materials  Put  In  Process  7. :.$40 ,000.00 

Inventory  of  Supplies, Jan. 1,191  190.00 

Purchases,   Including  In-Freight" 1,320.00 

$1,510.00 

Deduct—Inventory,  Dec .31,  191   210.00 

Supplies  Dsed  ~ 777777777   1,300.00 

Productive  Labor  17.700.00 

Prime  Cost   : $59,000.00 

Ron -Productive  Labor  $2 ,400.00 

Salaries,  Chargeable  to  Factory  2,200.00 

Power  2,100.00 

Light  and  Heat.  Chargeable  to  Factory   1,500.00 

Depreciation- -Machinery  500.00 

Repairs  and  Maintenance-- Machinery   950.00 

Depreciation-  -Bui  ldlngs.»..» 400.00 

Repairs  and  Maintenance  —  Buildings 800.00 

Depreciation—Factory  Office  Equipment   150.00 

Miscellaneous » 1. OOP. CO 

Fac  tory  Expense 

Cost  of  Manufacturing 

Inventory  of  Work  in  Process,  Jan.   1,  191_ $8,000.00 

Deduct-. Inventory  of  Work  In  Process, Deo .31,  191     6.000.00     2.000.00 

Cost  of  Goods  Manufactured   7.... ~"  ~~  |73,000.00 

FIG.  57. — Manufacturing  Statement 
Compare  with  Pig.  56. 

goods.  This  would  amount  to  an  analysis  of  the  item, 
"  goods  manufactured  during  the  period,  $73,000.00. ' ' 
Such  an  analysis  could  take  the  form  of  a  supplementary 
statement  as  shown  in  Figure  57.  This  supplementary 
statement  shows  in  great  detail  the  cost  of  manufactur- 
ing the  goods  which  were  turned  over  to  the  wholesale 
department  for  selling. 

It  might  be  desired  to  incorporate  this  information  in 
the  profit  and  loss  statement  itself,  and  this  could  easily 
be  done  by  striking  out  the  item  "  goods  manufactured 


234 


Principles  of  Accounting 


MAITOPACTURIHO,    TRADIMO,    AHD  PROFIT  AND  LOSS  STATEMENT- -BUSK     COKPAHI 
Year  Ending  D«c.51,  191_ 


£l  Sales    .. $133,300.00 


$155,100.00 


Inventory  of  Merchandl 
Inventory  of  Raw  Material 

Purchases  of~Raw*Material8,  .41.000.00 
JBO.000.00 
Deduct  —  Inventory  of  Ra 


n       x 

Purchases  of  Supplies, 
JM.l.  191_ 


|40(000t00 


:  ......  * 

1.320.00 


Deduct- -Invent OPT  of 

Supplies.   Dec.31.191_   ..          210.00 

Supplies   Used    1.30O.OO 

Productive  Laber   17.700.OQ 

Prime  Cost   •••    •• $59,000.00 

Non-Productlve   Labor t  2,400.OO 

Salaries,   Chargeable  to  Factory   2 ,200.00 

Light  and'Heatl'chargeabie'to'Faotory.        1)500. 00 

Depreciation— Machinery   500.00 

Repairs  and  Maintenance— Machinery   ...  950.00 

Depreciation—Buildings    400.00 

Repairs  and  Malntenence  — Buildings    ...  600.00 

Depreciation— Factory   Office   Equipment  150.00 

Miscellaneous    1.000.00 

Factory  Expense   , 13,000. 

Cost  of  Manufacturing ,... 

Inventory  of  Work  In  Process, Jan  1,191_  $8,000.00 
Deduct -Inventory  of  Work  In  Process, 

Deo .31,   191      C.000.00 

Add—Decrease  ln~Inventory   

Cost  of  Goods  Manufactured   , ...;• •     73.000.00 

|   88.000.00 

Deduct --Inventory  of  Merchandise, Dec. 31, 191  14.OOO.OO 

Cost  of  Goods  Sold ~ ;.' 

Gross  Profit  $ 


Selling  Coeta 

Salaries    |  7 ,000.00 

Traveling  Expense   3,000.00 

Telephones,   Telegrams,  and  Postage 700.00 

Depreciation— Sales  Office  Equipment   , 200.00 

Shipping  Expense   « 1,600.00 

Light  and  Heat— Sales    700.00 

Miscellaneous—Sales    500. OO 

Advertising  Purchased 10,000.00 


Advertising  Dept-Sal 
Advertising,  Telephone 
Depreciation  of  Advert 
Light  and  Heat — Advert 
Miscellaneous— Advert  1 


Ing 


4,800.00 
450.00 
350.00 
600.00 


Total  Selling  Cos 
Administration  Coats 

Salaries— General  Office   

Supplies—General   Office   

Postage,  Telephones,   ana  Telegrams—General. Of  flee 

Light  and  Heat— Qeneral   Office   

Depreciation— Off  toe  Equipment   

Miscellaneous --General  Office  Expense   

Total  Administration  Costs   

Total  Selling  and  Administration  Cost* 

Prime  Operating  Profit 

Other  Income 

Purchase  Discounts    

Interest  Received    

.      Mlecellaneou ~ 

Total  Other  Income 

Charges   to  Income 

Sales  Discounts   ~ 

Interest  Paid 

Insurance 

Taxes   

Bad  Debts 

Total   Charges   to   Income   

Met  Profit  for  t 
Surplus 

Balance  Sheet  Surplus,  Jar 


.$11,500.00 
2,600.00 
1,600.00 
2,600.00 
600.00 
1.800.00 


Year 


$200.00 
300.00 
100.00 


$200.00 
100.00 
800.00 
700.00 
300.00 


$85,000.00 


Deduct—Debit  Balance  of  Surplus  Adjust 
Balance  Sheet  Surplus,  Dec.  SI,   191_ 


Account  ..................   l.SOO.OO 


Fro.  58. — Complete  Statement  for  Manufacturing  Organization 
Compare  with  Figs.  56  and  57. 


Proprietorship 


235 


MOrif  AM)  LOSS  3TATSGNT  —  BLABS  COUP1XT 
Year  Ending  December  31.  m_ 


Inventory  of  Raw 

Material,  Jan.l.  191_ 
Purchases 

Inventory  of  Raw  Material 

Dec.  31.  191_ 
Supplies  Used 
Productive  Labor 

Prlne  Cost 

Bon-productlve  Labor 
Pectory  Salaries 
Power 
Light  and  Heat-P-actory 

pep.&  Halnt. -Machinery 
Depreciation-Buildings 
Rep.i  llalnt. -Buildings 
Depreclatlon-Offlte  Equip. 
Mlacellaneoua 

Cost  of  Manufacturing 
Inventories, Jan.l,  191_ 

Work  In  Process 

Finished  Goods 
Orosa  Profit  (red) 


Salaries  (Sales) 
Traveling  Expense  (Sales) 
Tel. .Tel..*  Postage  (Sales) 
Depreciation-Office  Equip. 

(Sales).. 

Light  and  Heat  (Sales) 
Miscellaneous  Oalos) 
Shipping  ?btpenae 
Advertising  Purchased 
Salaries  (Adv.) 
Tel., Tel.,*  Poatage  (Adv.) 
Depreciation- Of floe  Equip. 

(Adv.) 

Light  and  Heat (Adv.) 

Miscellaneous  (Adv.) 

Selling  Cost 

Administration 

Salaries 

Supplies 

Tel.. Tel.. 4  Poatage 

Light  and  Heat 

Depreoiatlon-0ffie«  Eoui 

Miscellaneous 

Administration  Cost 
Operating  Profit  (red) 


117.000.00 

3.000.00 

700.00 

£00.00 
700.00 
500.00 

1.500.00 
10.000.00 

4.800.00 
460.00 

350.00 
SOO.OO 

_  300, 00_ 


til. 500. 00 
2,500.00 
1.500.00 
£.500.00 
500.00 
1. SOO.OO 


Taxes 
Bad  Debts 

Charges  to  Income 
Met  Profit  for  year  (red> 


Surplus  Adjustments 
Surplus, Deo.  31,  191 


9  200.00 
100.00 
600.00 
700.00 
300.00 


Total  Sales 
Deduot-Retum  &  Allowance 

Gross  Income 
Inventories.  Iieo  31,  191_ 

Work  in  Process 

rial  abed  Qoode 


Gross  Profit 


Operating  Profit 
Purchase  Discounts 
Interest  Received 
Miscellaneous 
Other  Inoon 


H«t  Profit  for  ye«r 
Surplus,  tea  1.  191 


$800.00 
300.00 

100.00 


FIG.  59. — Statement  for  Manufacturing  Organization  in  Account  Form 


236  Principles  of  Accounting 


MODEL 

MABOFACTURIIIO.TRADIIO.AKD  PROFIT  AND  LOSS  STATEMENT  --BLASK  COMPAFT 
Tear  Ending  December  31,   191_ 

Gross   Income 

Total  Sales   $133,300.00 

Deduct- -Returned  Sales   and  Allowance* 200.00 

Oross  Income   7777777777. $133, 100. 

Production  Costs 

Inventory  of  Raw  Materials, 

Jan.l,  191   $9,000.00 

Purchases,  Including  In-Freight  


Deduct-  -Inventory,   Deo.  31,  191      ...................     10.000.00 

Materials   Put  In  Process   ----  77  ...............................  $40,000.00 

Inventory  of  Supplies,   Jan.l,l»l_  ................  $       190.00 

Purchases  Including   In-Freight   ......  .  ..............   1,320.00 

1,510.00 

Deduct—Inventory,  Dec.  31,  191  _  ...................    210.00 

Supplies  Used  ................................................  1,300.00 

Productive  Labor  .....  ........................................  17.700.00 

Prlae  Cost  ........................................................  $69,040,00 


Non-  Productive   Labor 

Salaries  Chargeable   to  Factory 

Powe 


Light  and  Heat  Chargeable   to   Factory 

Depreciation-  -Machinery 

Repairs   and  Maintenance—  Machinery 

Depreciation—Buildings 


Repa 

Depreciation  —  Factory  Office  Equlpne 


Misc 


ngs 
ulpn 


$2,400.00 

2,209.00 

2,100.00 

1,500.00 

500.00 

950.00 

400.00 

800.00 

150.00 

1.000.  00 


Pa«tory  Expanse   ..................................................    12.000.00 

Cost  of  Manufacturing   ....................................  $71,000.00 

Inventory  of  Work  In  Process,   Jan.l.m^  ..........  48.000.00 

Oeduct--inv<,rn.ory  or   »ork  In  Process,  Dec.  31,  191        ..      6^000.00     $2,000.00 
Inventory  of  Finished  Ooode,    Jan.  1,191        ......  77.  .  .$l£76oo.OO" 

Deduct—  Inventory  of  Finished  Goods,  De~31,191_   .  .  .14.000.00       1,000.00 

Cost   to   Produce  Goods  'sold'  ','.'.'.'.  '.'.'.'.'.'.','.'.'.'.'.'.'.'. 

Gross  Profit  ............................................... 


Selling  Cost* 

Salaries   .................................................  J  7,000.  00 

Traveling  Expense   .........................................      3,000.00 


,. 
Telephones,   Telegrams,   and  Postage   .  -  ..........  .  ...........          700.00 

Depreciation—Sales  Office  Equipment   .....................  200.00 


Shipping  Expense 
Light  and  Heat—Sales 
Miscellaneous—Sales 
Advertising  Purchased 
Advertising  Dept.  Sala 


Advertising—Telephones,  Telegrams,  and   Postage 


—,  , 

Bepreclatlon--Advertlslng  Office  Equ 
Light  and  Heat—Advertisin 
Miscellaneous—  Advertising 
Total  Selling  Cost 


ipment 


1,800.00 
700.00 
500.00 

10  OOO.OO 
4,800.00 
450.00 
350.00 
800.00 
300.OO 

- 


$30  000  00 


AOmistratlon  Costs 

Salaries—General  Office   .............................  $11  500  00 

Supplies—General  Office   ..................................      2,  500.  CO 

Postage,  Telephones  and  Telegrams—  General  Office  ...........      1,500.00 

Light  and  float—  General   Office   ......  ,  ........  .  ..........  .  ..     2,BOO.OO 

Depreciation—Office  Equipment   ............................          60O.OO 

Miscellaneous—  General  Office  Expense1.  ......  .  ...........  1.500.00 

Total   Administration  Costs   ........................  7  ~     2000000 

Total  Selling  and  Administration  Coato    "  ! 

Prime  Operating   Profit   .............................................  , 

Other  Incorce 

Purchase  Discounts   ...................................................     $  200.  OO 

Interest  Received   ..................  ;  .............................         300  OO 

Miscellaneous   ...................  .  ......................  .      . 

Total  Other   Incomes   ..............  ..........  ..  .....  '..  ....  ....  '..  .  .  .'.  ...... 

Charges  to  Income 

Sales  Discounts    ......................................................    ..$200.00 

Interest  Paid   .........................................................        100.00 

Tates8??:.:::::::::::::::: 

Bad  Debts 

Total  Charges  to  Inooae  ... 

Bet  Profit  for  the  Year  ................  .....i.  ...........  '.'.'.'. 

Surplus 

Balance  Sheet  Surplus,    Jan.  1,101      ...............  $86  000  00 

Deduct-Deblt  Balance  of  Surplua~Aaju.ti.ent  aeoouat'  .  ,[.'..  '.  .  '...'/.'.'.'.         llsooioo 

Balance  Sheet  Surpl 

FIG.  60.  —  Statement  for  Manufacturing  Organization  in  Somewhat  Different 

Form 


Proprietorship  237 

during  the  period,  $73,000.00,"  and  putting  in  its  place 
this  entire  manufacturing  statement.  (See  Figure  58.) 

The  reader  should  note  that  Figures  56  and  58  are  the 
same  except  that  one  item,  "goods' manufactured  during 
the  period,"  has  been  expanded  so  as  to  show  the  details 
composing  it.  Such  a  statement  as  the  latter  is  known 
as  a  "manufacturing,  trading,  and  profit  and  loss  state- 
ment." Very  often  such  a  statement  does  not  look  at  all 
like  the  simple  forms  heretofore  illustrated,  but  they  are 
exactly  the  same  in  their  fundamental  structure. 

A  company  that  buys  its  goods  is  not  interested  in  the 
cost  of  their  production,  but  when  it  manufactures  them, 
it  should  incorporate  in  the  profit  and  loss  statement  a 
detailed  statement  of  production  costs. 

There  are  other  standard  forms  of  presenting  such 
statements.  Figures  59  and  60  show  other  arrangements 
of  the  same  data  which  we  have  been  using.  The  report 
form  (Figures  58  and  60)  is  somewhat  preferred  because 
it  can  be  typewritten  more  easily  than  the  account  form. 
Furthermore,  it  has  the  advantage  of  being  more  easily 
understood  by  the  layman. 

BALANCE  SHEET  AND  PROFIT  AND  Loss  STATEMENT 

The  profit  and  loss  statement  is  equal  in  importance  to 
the  balance  sheet.  The  latter  is  a  snapshot  of  the  assets, 
liabilities,  and  proprietorship  of  a  business  at  a  definite 
instant  of  time.  The  former  shows  the  causes  which  have 
led  up  to  that  condition  and  bridges  the  gap  between  two 
successive  balance  sheets.  The  two  exhibits  are  always 
considered  together,  and  they  form  the  two  goals  of  the 
accountant.  The  one  without  the  other  is  incomplete. 
The  balance  sheet  shows  the  condition  of  the  business 
and  reveals  its  solvency,  but  it  does  not  show  its  profit- 
making  ability.  The  profit  and  loss  statement  shows  the 


238  Principles  of  Accounting 

current  profits  and  may  show  the  functional  efficiency  of 
the  business,  but  it  does  not  show  its  condition  at  any 
definite  time. 

THE  FUNCTIONAL.  IDEA 

We  have  seen  that  a  profit  and  loss  statement  whether 
in  account  form  or  in  report  form  generally  starts  with 
" gross  earnings  from  sales/'  This  amount  should  in- 
clude only  the  income  resulting  from  direct  operation. 
A  dry  goods  firm  might  make  total  sales  of  a  million  dol- 
lars and  might  have  an  additional  income  of  $200,000.00 
from  stocks  and  bonds  which  it  owned.  In  the  profit  and 
loss  statement,  the  income  from  its  investments  should 
not  be  merged  with  the  figure  representing  gross  sales. 
Here  we  have  the  functional  idea  very  clearly  illustrated. 
A  house  which  has  income  from  sales  of  merchandise  and 
income  from  investments  is  engaged  in  two  lines  of  busi- 
ness instead  of  one.  The  profits  from  its  trading  activi- 
ties should  not  be  confused  with  the  profits  from  its 
investments,  otherwise  the  results  of  all  activities  would 
be  obscured.  This  principle  of  "keeping  separate"  the 
various  classes  of  income  and  expense  is  of  fundamental 
importance.  One  engaged  in  two  different  lines  of  busi- 
ness will  desire  to  know  the  results  of  each  of  those  lines 
independently.  If  he  gets  only  a  lump  sum  representing 
profit  or  loss  in  his  total  activities,  he  cannot  know  which 
business  is  profitable  and  which  business  is  causing  him  a 
loss. 

An  excellent  illustration  of  this  principle  of  "keeping 
separate  "  occurs  in  dairy  farming.  Until  very  recently 
the  ordinary  farmer  was  content  to  know  whether  his 
herd  of  cows  as  a  whole  gave  him  satisfactory  returns. 
When  the  era  of  scientific  farming  began,  it  was  discov- 
ered that  a  great  difference  exists  between  individual 


Proprietorship  239 

cows.  The  dairy  farmer  today  keeps  a  record  for  each 
cow.  He  charges  each  with  her  total  costs  and  credits 
her  for  the  total  value  of  milk  produced,  and  when  he 
finds  that  the  animal  is  not  up  to  high  standard,  he  dis- 
poses of  her,  the  result  being  that  his  herd  produces  a 
very  much  greater  total  profit  than  under  the  old  system. 
This  same  principle  of  efficiency  has  been  applied  in  busi- 
ness for  many  years.  A  man  engaged  in  two,  three,  or 
four  lines  of  business  figures  their  expenses  and  profits 
separately. 

MODEL  FORM  OF  STATEMENT 

Mr.  A.  Lowes  Dickinson,  a  prominent  certified  public 
accountant,  submitted  the  following  model  form  of  profit 
and  loss  statement  to  the  St.  Louis  Congress  of  Account- 
ants in  1904 : 

Gross  Earnings  From  Sales $ 

Less — Returns,  Allowances,  and  Discount 


Net  Earnings  from  Sales $ . 

Deduct — Cost  of  Production  or  Service 


Gross  Profit $. 

Deduct — Cost  of  Selling $ 

Expenses   of   Management 


Net  Profit  from  Operations $ . 


Net  Profit  from  Operations $ 

Other  Income $ . 

Deduct — Interest  on  Bonds $ 

Other  Fixed  Charges 


Surplus  for  Year $ . 

Extraordinary  Profits    (detailed) 

Surplus  Brought  Forward  from  preceding  year 


$. 


240  Principles  of  Accounting 

1  Deduct — Extraordinary    Charges 


Total  Surplus  Available, 
Dividends  on  Stocks . . 


Surplus  Carried  Forward $. 


This  form  has  been  rather  generally  adopted  by 
accountants,  although  individual  variations  are  only  to 
be  expected.  While  not  absolutely  necessary,  it  is  always 
desirable  to  reconcile  the  figure  representing  net  profits 
for  a  period  with  the  surplus  as  shown  by  the  balance 
sheet  of  the  same  period.  This  surplus  figure  will  be 
fully  accounted  for  in  this  way.  The  proper  method  of 
handling  such  a  reconciliation  on  the  profit  and  loss  state- 
ment is  to  append  a  supplementary  section,  as  has  been 
shown  in  the  previous  illustrations. 

TKADING  ACCOUNT 

There  are  many  widely  different  opinions  as  to  just 
what  items  should  be  included  in  the  trading  section  of 
the  profit  and  loss  statement.  Authorities  differ  on  this 
subject  more  than  on  any  other.  Professor  Henry  Rand 
Hatfield's  standard  work,  Modern  Accounting,  speaks  of 
the  Trading  Account  as  follows:  "Ignoring  variations 
and  mere  detail,  two  divergent  customs  are  found.  One 
includes  in  the  Trading  Account  all  the  expenses  con- 
nected with  trafficking  as  distinct  from  the  general  ex- 
penses of  management — the  second  and  more  rigid 
method  excludes  from  the  Trading  Account  all  items  ex- 
cept those  representing  the  direct  cost  price  and  the  net 
selling  price  of  the  goods  handled ;  the  balance  then  car- 
ried down  is  generally  called  gross  trading  profits. ' ' 

Dr.  Joseph  J.  Klein  in  his  book  on  accounting  includes 
all  selling  expenses  in  the  trading  sections  of  his  profit 


Proprietorship  241 

MICHIGAN  MANUFACTURING  COMPANY 
MANUFACTURING,    TRADING,     AND    PROFIT    AND    LOSS    STATEMENT 

Year  ending  May  31.  1910 
Income  from  Sales 

Total     Sales $187.540.38 

Cost  of  Goods  Sold 

Prime  Cost  of  Goods  Finished  during  period 

Inventory — Manufacturing     Materials,     June     1, 

1909    $    27,214.41 

Add— Purchases     106,634.12 

Freight.    Express    &    Cartage    "In" 1,734.70 

$135,583.23 
Deduct — Inventory    of   Manufacturing    Materials, 

May    31,    1910 51,358.58     $    84,224.65 


Purchases— Manufacturing     Supplies- $      1,631.09 

Less— Inventory   of   Manufacturing    Supplies 200.00  1,431.09 

Production    Labor....  63.842.23 


Total    Prime    Cost $149,497.97 


Factory    Expense 

Non-Productive    Labor $      1,993.50 

Depreciation — Machinery    and   Equipment 1,234.49 

Repairs    to    Machinery 507.73 

Fuel    Purchased $      5,554.82 

Deduct— Inventory,    Alay    31,     1910 2,188.40  3,366.42 

Insurance    Expired 2,152.14 

Water    Tax 140.53 


$      9,394.81 

Total  Manufacturing  Cost  for  period $158,892.78 

Deduct — Inventory  of  Goods  in  Process,  May  31,   1910 1,820.00 

Manufacturing  Cost  of  Goods  Finished $157,072.78 

Deduct — inventory    of    Finished    Goods 3,210.00 


Manufacturing   Cost  of  Goods  Sold $153,862.78       153,862.78 


Gross    Profit $    33,677.60 

Selling   Expense 

Advertising     $          378.58 


Administrative  Expense 

Salaries    $  6.170.00 

Stationery   and  Office   Supplies 296.02 

Miscellaneous   Office   Expense 241.08 

Postage    .'. 264.42 

$  6.9.71.52 


General  Expense 

Stable  Expenses $      1,679.89 


Total    Selling,    Administrative,    and   General   Expense $      9,029.99  9.029.99 

$    24.647.61 
Additional  Income 

Miscellaneous     Earnings $          724.75 

Purchase    Discounts 2,081.59 

Interest     Earned 463.17 


Total  Additional  Income $      3,269.51  3,269.51 

Total    $    27,917.12 

Deductions  from  Income 

Taxes     $  376.75 

Bad     Debts 9,128.11 

Interest  Paid 3,521.63 

Sales    Discounts 3,362.19 


Total    Deductions    from    Income $    16,388.68         16,388.158 


Net  Profit  for  year  ending  May  31.  1910 $    11,528.44 

Undivided  Profits   as  per   Balance   Sheet 11,528.44 

FIG.  61. — Illustration  of  the  Profit  and  Loss  Statement  for  the  Problem 

Discussed  in  Chapter  IV,  pages  134  to  141 

Compare  with  Fig.  44. 


242  Principles  of  Accounting 

and  loss  statements.  Professor  Wm.  Morse  Cole's 
Accounts,  Their  Construction  and  Interpretation,  does 
not  follow  any  of  the  ordinary  accounting  practices. 
What  most  accountants  would  call  the  Trading  Account, 
he  designates  as  "Merchandise  Account, ;>  and  in  the 
Trading  Account  includes  items  of  rent,  wages,  insurance, 
depreciation,  advertising,  losses  from  bad  debts,  and 
general  expenses. 

In  spite  of  the  divergent  opinions  of  certain  eminent 
authorities,  it  would  seem  that  the  majority  of  account- 
ants favor  the  practice  of  including  in  the  trading  state- 
ment only  those  items  representing  the  cost  price  and  the 
net  selling  price  of  the  goods  sold. 

TREATMENT  OF  ERRORS 

If  errors  should  be  made  in  an  accounting  period  and 
certain  items  of  income  or  expense  should  not  be  discov- 
ered until  after  the  books  had  been  closed,  they  should 
not  be  considered  as  the  income  or  expense  of  the  subse- 
quent period.  The  reason  for  this  is  clear.  Each 
accounting  period  must  stand  alone.  A  profit  and  loss 
statement  for  one  period  should  include  all  income  ap- 
plicable to  that  period  and  all  expenses  for  which  that 
period  is  responsible.  If  the  income  or  expense  of  one 
period  is  treated  as  the  income  and  expense  of  a  subse- 
quent period,  the  results  of  both  accounting  periods  will 
be  wrong.  The  profits  for  one  period  will  be  understated 
and  for  the  other  period  overstated  by  the  same  amount, 
and  should  the  error  involve  a  substantial  sum,  no  just 
comparison  can  be  made  between  the  two  periods. 

Should  such  omissions  and  errors  be  detected,  the  cor- 
rections should  be  made  by  means  of  charges  or  credits  to 
the  Surplus  Account.  If  a  $100.00  item  of  expense  for 
one  period  is  omitted,  the  profits  for  that  period  will  be 


Proprietorship  243 

overstated  and  the  final  credit  to  the  Surplus  Account 
will  be  too  large  by  $100.00.  When  the  error  is  discov- 
ered, the  correction  should  be  made  to  the  account  in 
which  the  error  is  reflected — the  Surplus  Account.  Even 
the  best  bookkeepers  make  such  errors,  and  where  they 
are  likely  to  prove  numerous,  it  is  considered  good  prac- 
tice to  open  up  a  Surplus  Adjustment  Account,  in  which 
such  correcting  entries  are  assembled.  The  balance  of 
the  Surplus  Adjustment  Account  is  then  transferred  to 
the  Surplus  Account  as  one  item.  This  prevents  the  Sur- 
plus Account,  which  is  an  important  one,  from  being 
loaded  up  with  a  number  of  minor  adjustments. 

MATEKIALS  AND  SUPPLIES 

In  a  profit  and  loss  statement  it  is  customary  to  show 
the  starting  inventory,  the  net  purchases,  and  the  final 
inventory  in  order  to  arrive  at  the  cost  of  materials  and 
supplies  used.  This  form  is  universally  employed  be- 
cause of  its  clearness.  Where  the  Purchase  Account  is 
not  kept,  being  replaced  by  a  Materials  Account — a  con- 
trolling account  over  perpetual  inventory  records — it  is 
necessary  to  restate  the  Materials  Account  in  order  to 
obtain  the  figures  for  the  profit  and  loss  statement. 

In  a  perpetual  inventory  system  the  controlling  account 
is  charged  with  purchases  at  cost  and  is  credited  with 
withdrawals  of  materials  at  cost.  The  balance  of  such 
an  account  is  equivalent  at  all  times  to  materials  actually 
on  hand.  Figures  62  and  63  show  the  Eaw  Materials 
Account  and  the  Supplies  Account  of  the  Blank  Company. 
Postings  are  made  to  these  accounts,  in  monthly  totals, 
from  the  voucher  register  and  the  requisition  journal. 

A  comparison  of  the  profit  and  loss  figures  shown  in 
Illustration  58  with  these  two  accounts,  will  indicate  the 


244 


Principles  of  Accounting 


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Q    <t 

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Proprietorship 


245 


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246  Principles  of  Accounting 

method  used  where  the  perpetual  inventory  system  is 
used. 

PRIME  COST 

It  is  fairly  well  agreed  among  cost  accountants  that 
prime  cost  consists  of  direct  materials  and  direct,  or  pro- 
ductive, labor.  Direct  supplies  may  also  be  included 
under  certain  conditions.  The  figure  representing  prime 
cost  is  an  important  one  from  the  cost  accountant's  view- 
point. Direct  materials  are  those  which  are  to  be  manu- 
factured into  finished  goods.  Direct  labor  is  that  of  the 
workmen  who  are  actually  engaged  in  the  process  of 
manufacturing.  Direct  supplies  are  those  which  are  so 
intimately  connected  with  the  manufacturing  process  that 
they  can  be  directly  charged  against  a  given  job  or  order 
number.  Non-productive  labor  is  misnamed,  since  it  is 
very  often  productive  and  the  adjective  "indirect"  is 
much  more  appropriate.  A  superintendent  is  certainly 
engaged  in  productive  work,  but  his  salary  is  not  a 
"direct"  charge. 

MANUFACTURING  EXPENSE 

Manufacturing  expenses  or  "overhead"  consist  of  the 
various  items  of  expense  which  cannot  be  directly 
charged  to  a  given  job.  In  the  ordinary  factory  most  of 
the  expenses  are  of  this  nature.  Depreciation  of  plant, 
depreciation  of  machinery,  heat  and  light,  water,  power, 
etc.,  may  all  be  items  of  factory  or  overhead  expense. 

FACTORY  PROFITS 

Many  accountants  argue  that  if  the  factory  is  consid- 
ered a  function,  separate  and  distinct  from  other  func- 
tions, it  is  entitled  to  a  profit  on  the  goods  which  it  makes 
and  turns  over  to  another  department  to  sell.  If  the 
factory  should  make  an  article  at  the  cost  of  $1.50,  the 


Proprietorship  247 

current  market  price  of  which  was  $2.00,  these  account- 
ants argue  that  the  factory  should  bill  this  article  to  the 
sales  department  at  $2.00,  thus  making  a  factory  profit  of 
50  cents.  This  has  good  points  to  recommend  it,  since  the 
total  factory  profit  for  a  given  accounting  period  will 
show  the  total  amount  which  the  concern  has  saved  by 
manufacturing,  instead  of  purchasing,  its  goods. 

The  principal  objection  is  that  this  procedure  serves 
to  anticipate  profits.  An  article  that  is  manufactured 
for  $1.50  is  transferred  to  the  finished  goods  warehouse 
at  $2.00  and  appears  in  the  inventory  of  finished  goods  at 
the  same  figure.  The  inventory,  therefore,  does  not  value 
goods  at  cost  price,  but  at  cost  price  plus  the  manufactur- 
ing profit. 

We  have  seen  in  Chapter  V  that  merchandise  must  be 
valued  at  its  actual  cost  to  the  going  concern.  The  taking 
of  a  factory  profit  is  clearly  improper  from  the  stand- 
point of  the  business  as  a  whole,  since  it  is  not  in  line 
with  this  principle  of  valuation.  A  company  which  in- 
sists on  such  a  procedure  may  overcome  this  difficulty 
by  setting  up  a  reserve  for  an  amount  equal  to  the  antici- 
pated profits  on  unsold  goods.  The  author  sees  no  reason 
why  a  factory  profit  should  ever  be  recognized  on  the 
general  books.  The  factory  cost  is  always  known  from 
the  manufacturing  statement,  the  market  price  can  easily 
be  determined,  and  supplementary  exhibits  may  be  pre- 
pared to  show  what  the  factory  profits  would  have  been. 

It  may,  therefore,  be  stated  without  fear  of  successful 
contradiction  that  the  best  method  is  to  book  all  finished 
goods  at  actual  manufacturing  cost. 

DEPRECIATION 

While  the  subject  of  depreciation  will  be  more  exten- 
sively treated  in  Chapter  XII,  it  is  well  to  state  at  this 


248  Principles  of  Accounting 

point  that  depreciation  of  machinery,  tools,  factory  equip- 
ment, factory  fixtures,  and  factory  buildings  are  costs 
and  should  be  included  in  the  manufacturing  statement. 
They  form  part  of  the  cost  of  production  and  should  never 
be  considered  as  deductions  from  profits.  Many  other- 
wise well-informed  accountants  fail  to  treat  depreciation 
as  a  cost.  They  set  up  a  reserve  for  depreciation,  which 
is  in  the  nature  of  appropriated  surplus — profits  which 
have  been  set  aside  or  "  earmarked. ' '  Depreciation  has 
no  reference  whatever  to  profits  and  must  be  booked  even 
if  no  profits  should  be  made.  It  is  as  much  an  expense 
as  coal  which  is  burned  under  the  boilers. 

Depreciation  of  general  office  equipment  is  an  adminis- 
tration expense  and  should  be  so  booked.  Depreciation 
of  sales  office  equipment  is  a  selling  expense  and  should 
be  so  treated, 

PUKCHASE  AND   SALES  DISCOUNTS 

There  is  a  lack  of  agreement  between  prominent 
accountants  as  to  the  proper  treatment  of  purchase  and 
sales  discounts,  one  group  claiming  that  a  purchase  dis- 
count is  equivalent  to  a  reduction  in  the  cost  of  goods 
purchased,  while  others  consider  a  purchase  discount  a 
financial  gain  due  to  the  possession  of  ample  capital.  If 
the  former  viewpoint  is  adopted,  merchandise  purchases 
will  be  booked  at  the  cost  laid  down  at  the  purchaser's 
warehouse,  less  the  amount  of  purchase  discount.  In  the 
former  case  they  will  be  charged  to  the  Purchases 
Account,  less  the  amount  of  purchase  discount.  In  the 
latter  case  they  will  be  charged  to  the  Purchases  Account 
at  the  cost  laid  down  in  the  warehouse. 

These  two  different  viewpoints  involve  different  treat- 
ments in  the  profit  and  loss  statement.  If  the  purchase 
discounts  are  regarded  as  reducing  the  cost  of  goods  pur- 


Proprietorship  249 

chased,  then  they  will  appear  in  the  manufacturing  or 
trading  section  of  the  profit  and  loss  statement,  but  if 
they  are  regarded  as  items  of  "other  income/'  they  will 
appear  in  the  financial  section  of  the  profit  and  loss  state- 
ment. In  order  to  illustrate  the  difference  in  treatment 
let  us  assume  two  different  concerns  with  the  same  profit 
and  loss  figures.  It  will  be  noted  that  Company  A  treats 
purchase  discounts  as  a  reduction  in  the  cost  of  purchases, 
while  Company  B  regards  them  as  additional  income. 

PROFIT  &  LOSS  STATEMENT  PROFIT  &  LOSS  STATEMENT 

A    Company  B  Company 

Year   ending    Dec.    31,    1915  Tear   ending   Dec.    31,    1915 

Sales     $10.000.00        Sales     $10,000.00 

Inventory     1/1/15....     $1,000.00  Inventory     1/1/15 $1,000.00 

Purchases    $8,000.00  Purchases     8,000.00 

Less — Dis-  

counts..          200.00       7,800.00  $9, 000. 00 


•*•   "^   w  » 

Cost  of  Goods  Sold    

7  700.00 

7  500  00 

$    2  300.00 

000  00 

Gross     Profit  

.     $    2,500.00 

Admin.     Expense  

800.00 

1,800.00 

Selling    Expense  
A  dmin  .     Expense  — 

$1,000.00 
800.00          1,800.00 

$        500.00 

Other  Income 
Interest      

$        700.00 
80.00 

Other   Income 
Interest    $ 

80  00 

*        7  an  nn 

Purchase    Discounts.. 

200.00 

280.00 

Income     Charges 200.00  $        780.00 

Income    Charges 200.00 

Net   Profit  for  year $        580.00  

Surplus      1/1/15 3,000.00  $        580.00 

Surplus     1/1/15 3.000.00 

Surplus     12/31/15 $    3,580.00  

.        Surplus   12/31/15 $    3,580.00 


The  final  net  profit  is  the  same  whichever  method  of 
handling  purchase  discounts  is  adopted,  but  the  "cost  of 
goods  sold"  and  "the  gross  profit"  for  the  two  com- 
panies differ. 

The  analysis  of  the  nature  of  such  discounts  leads  us 
inevitably  to  the  conclusion  that  they  are  offered  for  the 
purpose  of  making  prompt  collections.  A  business  offers 
a  cash  discount  in  order  that  its  customers  will  remit 
promptly.  As  an  inducement  for  promptness  in  making 
payment,  the  cash  discount  implies  a  need  for  money. 


250  Principles  of  Accounting 

The  value  of  its  merchandise  certainly  cannot  be  depend- 
ent upon  the  quantity  of  working  capital  which  a  concern 
possesses. 

Consider  the  case  of  two  concerns  each  buying  a  bill  of 
merchandise  amounting  to  $100.00.  One  is  in  strong 
financial  condition,  has  sufficient  funds  to  discount  its 
bills,  and  takes  advantage  of  the  2%  discount  offered. 
It,  therefore,  will  book  this  merchandise  at  $98.00  (disre- 
garding incoming  freight  and  drayage).  The  other  is 
short  of  working  capital  and  does  not  take  the  discount. 
It,  therefore,  books  the  same  merchandise  at  $100.00.  It 
is  unreasonable  to  claim  that  the  concern  which  is  in 
strong  financial  condition  should  value  its  merchandise 
at  a  lower  figure  than  the  concern  which  is  in  straightened 
circumstances.  The  value  of  that  merchandise  to  each  is 
the  same  and  should  be  booked  at  the  same  figure,  namely 
$100.00.  The  one  in  strong  financial  condition  must  con- 
sider the  $2.00  discount  as  being  income  due  to  its  posses- 
sion of  adequate  capital.  It  seems  inevitable,  therefore, 
that  purchase  discounts  must  be  considered  as  "other 
income "  rather  than  as  a  reduction  of  the  purchase 
price. 

Sales  discounts  to  the  seller  are  purchase  discounts  to 
the  buyer.  If  the  purchase  discount  must  be  regarded 
as  "other  income "  which  is  financial  in  its  nature,  the 
same  discount  from  the  viewpoint  of  the  seller  must  be 
considered  as  a  financial  cost  and  not  as  a  deduction  from 
sales.  Sales  discounts  are  offered  for  the  purpose  of 
making  prompt  collections  and  thus  renewing  the  cash 
capital  of  the  seller.  It  is  an  amount  paid  for  the  use  of 
capital  and  is  clearly  the  same  kind  of  an  item  as  interest 
paid  and  must  be  treated  in  the  same  way,  namely,  as  a 
financial  cost. 


Proprietorship  251 

INSURANCE  AND  TAXES 

Just  what  disposition  should  be  made  of  insurance  and 
taxes  on  the  profit  and  loss  statement  is  sometimes  rather 
puzzling.  Many  accountants  argue  that  inasmuch  as 
insurance  is  a  cost  incurred  for  the  protection  of  capital, 
it  would  be  an  error  to  charge  it  as  a  manufacturing 
expense.  They  would  treat  expired  insurance  as  a  reduc- 
tion from  income.  Taxes  are  regarded  in  much  the  same 
way  as  a  charge  incurred  because  of  the  possession  of 
capital,  and  not  as  a  factor  in  the  cost  of  manufacturing. 

Some  accountants  hold  that  these  items  should  be 
treated  as  a  manufacturing  expense,  and  it  should  be 
noted  that  this  is  the  viewpoint  of  the  cost  accountant 
and  the  engineer,  rather  than  the  ordinary  commercial 
accountant.  The  goal  of  the  cost  accountant,  as  has  been 
so  ably  expressed  by  A.  Hamilton  Church,  is  to  load  all 
expenses  on  work  in  process  "at  the  point  of  the  tool." 
The  effect  of  this  is  to  swell  inventory  values  of  finished 
and  partly  finished  goods,  and  for  this  reason  the  auditor 
is  inclined  to  look  askance  on  such  procedure. 

The  disposition  of  such  items  as  insurance  and  taxes 
must  not  be  treated  dogmatically ;  but  as  a  general  propo- 
sition it  may  be  said  that  expired  insurance  premiums  on 
raw  materials  and  work  in  process  may  be  legitimately 
treated  as  a  manufacturing  expense.  Insurance  on  build- 
ings, machinery,  and  other  fixed  assets  may  be  regarded 
as  a  financial  cost  and  handled  as  a  reduction  of  income. 
It  is  probably  better  practice  to  regard  taxes  as  a  reduc- 
tion of  income,  i.  e.,  a  financial  cost. 

BAD  DEBTS 

Shall  losses  from  bad  debts  be  regarded  as  a  sales 
expense,  an  administration  expense,  or  a  reduction  from 


252  Principles  of  Accounting 

income?  The  answer  to  this  question  will  determine  how 
the  item  is  to  be  treated  on  the  profit  and  loss  statement. 
No  definite  answer  can  be  given  until  we  have  definite 
information  as  to  the  responsibility  for  granting  credit. 
If  the  sales  department  determines  credits  or  if  the  credit 
department  is  subsidiary  to  the  sales  department,  this 
item  can  be  properly  treated  as  a  charge  to  the  selling 
function. 

Usually  the  credit  department  is  installed  to  act  as  a 
check  upon  the  sales  department,  restricting  its  activities. 
The  credit  department's  function  is  to  increase  profits  by 
reducing  losses  from  bad  debts,  but  if  a  credit  depart- 
ment is  so  strict  that  it  has  no  losses  whatever,  it  is  clearly 
evident  it  has  not  performed  its  functions  properly.  It 
has  probably  turned  away  desirable  business.  Theoret- 
ically, therefore,  the  credit  department  is  engaged  in 
increasing  net  results  through  a  wise  selection  of  cus- 
tomers. The  credit  department  is  usually  superintended 
by  the  financial  officer  of  the  company,  i.  e.,  the  treasurer 
or  secretary,  and  since  all  his  departmental  expenses  are 
treated  as  administration  costs,  it  would  seem  proper  to 
include  losses  from  bad  debts  in  the  same  category.  There 
are  also  good  arguments  in  favor  of  treating  them  as 
financial  costs. 

CLOSING  THE  LEDGER 

At  the  end  of  each  accounting  period  when  the  nominal 
accounts  are  to  be  closed  out,  it  is  convenient  to  have  on 
the  books  a  Trading  Account,  Profit  and  Loss  Account, 
Income  Account,  and  Profit  and  Loss  Allocation  Account 
and  to  make  the  closing  entries  to  these  summary  accounts 
instead  of  to  a  general  classified  profit  and  loss 
account.  By  dosing  in  sections  the  figures  are  preserved 
in  the  General  Ledger  itself  in  convenient  form.  This 
is  more  a  matter  of  technique  than  of  principle,  but  it  is 


Proprietorship  253 

in  line  with  modern  practice.  Many  accountants  con- 
sider it  a  waste  of  time  actually  to  open  these  accounts 
and  prefer  to  close  all  nominal  items  out  into  the  Undi- 
vided Profits  Account  or  the  Surplus  Account.  An  illus- 
tration of  closing  journal  entries  and  the  resulting 
general  ledger  accounts  are  shown  in  Figures  64  and  65. 

STATEMENT  OF  RECEIPTS  AND  DISBURSEMENTS 

A  very  careful  distinction  should  be  made  between  a 
profit  and  loss  statement  and  a  statement  of  cash  receipts 
and  disbursements.  The  latter  is  merely  a  classified  rear- 
rangement of  the  Cash  Book  in  statement  form,  showing 
all  items  of  cash  receipts  classified  according  to  their 
sources  and  cash  disbursements  classified  according  to 
their  application,  the  balancing  figure  representing  cash 
on  hand  at  the  end  of  the  period.  A  statement  of  cash 
receipts  and  disbursements  can  in  no  way  take  the  place 
of  a  profit  and  loss  statement,  since  earnings  and  income 
received  in  cash  during  a  certain  period  may  be  repre- 
sented by  entirely  different  figures.  Liabilities  incurred 
and  liabilities  paid  would  very  seldom  be  equal  in  amount 
for  a  given  accounting  period.  While  a  statement  of  cash 
receipts  and  disbursements  is  often  desirable  in  connec- 
tion with  an  annual  report,  it  can  be  considered  as  a  mere 
formal  rearrangement  of  the  information  contained  in  the 
Cash  Book. 

EAILKOAD  INCOME  STATEMENTS 

Railroad  accounting  is  a  distinct  subject  in  itself,  and 
it  is  not  proposed  to  discuss  it  in  this  volume.  The  classi- 
fications and  treatments  are  prescribed  by  the  Interstate 
Commerce  Commission,  and  a  thorough  familiarity  with 
their  regulations  is  essential  to  the  man  who  desires  to 
acquaint  himself  with  this  branch  of  accounting. 


254 


Principles  of  Accounting 


JOURNAL— BLANK  COMPANY 
191.. 

Dec.  31     Total   Sales $133,300.00 

Merchandise — Inventory,  Dec.   31,    191 — 14,000.00 

Returned  Sales  and  Allowances $      200.00 

Merchandise — Inventory,   Jan.  1,   191 — 15,000.00 

Purchases   73,000.00 

Trading  Account 59,100.00 

(Although  from  this  journal  entry  only  one 
posting  to  the  Trading  Account  is  required, 
it  is  customary  actually  to  show  all  the 
details,  as  though  they  had  been  posted) 

31     Trading   Account — To    Close 59,100.00 

Selling — Salaries     7,000.00 

Traveling  Expense   3,000.00 

"          Tel.,   Tel.,   &   Postage 700.00 

"          Depreciation  of  Equipment 200.00 

"          Shipping   Expense    1,500.00 

Light    and    Heat 700.00 

"          Miscellaneous    500.00 

Advertising  Purchased    10,000.00 

Dept— Salaries    4,800.00 

Tel.,  Tel.,  &  Postage 450.00 

"                          Depreciation  of  Equip 350.00 

"                         Light   and   Heat.. 500.00 

"                         Miscellaneous    300.00 

Administration — Salaries    11,500.00 

Supplies    2,500.00 

Tel.,  Tel.,  &  Postage 1,500.00 

Light  and  Heat 2,500.00 

"    .              Depreciation  of  Equipment    500.00 

Miscellaneous    1,500.00 

Profit  and  Loss  Account 9,100.00 

Dec.  31     Profit  and  Loss  Account — To  Close 9,100.00 

Purchase  Discounts    200.00 

Interest  Received   300.00 

Miscellaneous 100.00 

Sales   Discounts    200.00 

Interest  Paid    100.00 

Insurance     800.00 

Taxes    700.00 

Bad   Debts   300.00 

Income  Account   7,600.00 

31     Surplus  Account 1,800.00 

Surplus   Adjustment   Account 1,800.00 

31     Income  Account — To  Close  B 7,600.00 

Surplus  Account 7,600.00 

B  This  amount  might  properly  be  closed  into  the  Profit  and  Loss  Allocation 
Account  and  from  there  to  Surplus,  but  this  step  may  be  eliminated  when  there 
is  no  allocation  to  be  made. 

FIG.  64. — Closing  Journal  Entries 


Proprietorship 


255 


LEDGER— BLANK   COMPANY 
TRADING  ACCCKJNT 


Dec.  31  Ret.    Sates    & 
Allowances    ....(J)  $        200.00 
31  Mdse      Inv           (j)       15  000  00 

Dec.  31  Gross    Sales  (j)  $133,300.00 
31  Mdse.—  Inv.    .  .  .  (j)       14,000.00 

31  Purchases              (j)       7300000 

31  P.&L.—  To  Close  (j)      59,100.00 

$147,300.00 

$147,300.00 

PROFIT  AND  L 

-ess  ACCOUNT 

Dec.  81  Selling  —  Salaries  (J)  $  7,000.00 
31  Traveling   Exp       (J)       3  000  00 

Dec.  31  Trading  Acct.   ..(j)  $59,100.00 

31  Selling—  T.,  T.,  & 
p            .  .  (J)          70000 

31        "     Depn.  Equip,  (j)          200.00 
31        "     Ship'g    Exp.(j)       1,500.00 
31        "     Lt.  &  Heat  (J)          700.00 
31        "     Misc.    EXp.  (j)          500.00 
31  Adv     Purch.          (J)    1000000 

31  Adv.—  Salaries   ..(J)      4,800.00 
31       "    T.,   T.,  &  P.(J)          450.00 
31      "    Depn.   Equip.  (J)          350.00 
31      "    Lt.  &  Heat.,  (j)          500.00 
31      "    Misc  (J)          300.00 
31  Adm.  —  Salaries    .  (J)    11,500.00 
31       "     Supplies    .  .  (J)      2,500.00 
31       "    T.,  T.,  &  P.  (j)       1,500.00 
31       "     Lt.  &Heat.(J)       2,500.00 
31       "     Depn.  Equip,  (j)          500.00 
31        "     Misc           .    (j)       1  500  00 

• 

31  Income  —  To  Close  (J)       9,100.00 

$59,100.00 

$59,100.00 

INCOME 

ACCOUNT 

Dec.  31  Sales    Discounts.  .  (j)  $    200.00 
31  Interest  Paid  (J)       100.00 

Dec.31  Profit  &  Loss  (J)  $9,100.00 
31  Purch    Dscts.    .      (j)        20000 

31  Insurance     (J)       800.00 

31  Interest  Rec'd          (  j)       300  00 

31  Taxes  (  J)        700.00 

31  Misc    Income           (  j)       100  00 

31  Bad  Debts   (J)        300.00 

31  Surplus     (J)    7,600.00 

$9,700.00 

$9,700.00 

SURPLUS 

ACCOUNT 

Dec  31  Adjustments          (J)  $  1  800  00 

Jan    1  Balance           ....  (J)  $85,000.00 

31  Balance   V    90,800.00 

Dec.31  Income    a/c.  .  .      (j)       760000 

$92,600.00 

$92,600.00 

Jan.   1  Balance    .             ..  v/  $90.800.00 

FIG.  65. — Ledger  Accounts  after  Closing 


256  Principles  of  Accounting 

INCOME  STATEMENT— NORTHERN  PACIFIC  EAILWAY 

COMPANY 

For  fiscal  year  ending  June  30,  1912 
Kevenue  from  Transportation 

Freight $43,332,918.23 

Passenger 17,278,812.52 

Other  Revenue  from  Transportation 3,456,962.01 


Total   $64,068,692.76 

Revenue  from  Operation  Other  Than  Transportation 844,139.13 


Total  Operating  Revenue $64,912,831.89 

Operating  Expenses 

Maintenance  of  Way  and  Structures $  8,065,462.47 

Maintenance  of  Equipment 7,911,231.46 

Traffic   Expenses 1,127,233.05 

Transportation  Expenses 21,601,477.48 

General   Expenses 1,024,356.05 

Total   .  39,729,760.51 


Net  Operating  Revenue $25,183,071.38 

Outside  Operations 

Sleeping,  Parlor,  Observation,  Dining,  and  Cafe  Cars 

and  Restaurants 441,802.83 


Total  Net  Revenue $25,624,874.21 

Taxes   Accrued 3,296,797.49 


Operating    Income $22,328,076.72 

Other  Income 

Dividends  and  Interest  on  Securities,  In- 
terest on  Deposits  and  Miscel- 
laneous   $  2,705,981.83 

Rentals  Received 2,027,352.75 

Hire  of  Equipment 607,094.46 

Total   . 5,340,429.04 


Gross    Income $27,668,505.76 

Deduct 

Rentals   Paid $     561,149.26 

Interest  on  Funded  Debt 6,665,090.00 

Dividends  on  Stock 17,360,000.00 


Total   24,586,239.26 


Net  Income  for  Year $  3,082,266.50 

FIG.  66. — Railroad  Income  Statement 


Proprietorship  257 

The  first  item  to  appear  on  the  Income  Statement  (see 
Figure  66)  of  a  railroad  is  revenue.  This  is  divided  into 
1  'Re venue  from  Transportation "  and  ' 'Revenue  from 
Operation  other  than  Transportation. "  Revenue  from 
Transportation  is  of  three  kinds : 

1.  Freight  revenue. 

2.  Passenger  revenue. 

3.  Other  revenue  from  transportation. 

From  the  Total  Operating  Revenue  is  deducted  the 
Operating  Expenses.  Operating  Expenses  are  consid- 
ered under  five  general  heads : 

1.  Maintenance  of  Way  and  Structures. 

2.  Maintenance  of  Equipment. 

3.  Traffic  Expenses. 

4.  Transportation  Expenses. 

5.  General  Expenses. 

The  figure  obtained  by  deducting  Operating  Expenses 
from  Total  Operating  Revenue  is  designated  as  "net 
operating  revenue "  and  to  this  is  added  Income  from 
Outside  Operations,  such  as  "sleeping,  parlor,  observa- 
tion, dining,  and  cafe  cars  and  restaurants, "  giving  the 
"Total  Net  Revenue. "  Taxes  are  then  deducted  from 
this  amount  giving  "operating  income "  to  which  is  added 
"Other  Income/'  such  as: 

1.  Dividends  and  Interest  on  Securities, 

Interest  or  Deposits,  Miscellaneous, 

2.  Rentals  Received. 

3.  Hire  of  Equipment. 

The  figure  obtained  from  adding  Other  Income  to  Oper- 
ating Income  may  be  called  "Gross  Income. "  From 


258  Principles  of  Accounting 

Gross  Income  will  be  deducted  Kentals  Paid  and  Interest 
on  Funded  Debt. 

The  reader  who  is  desirous  of  making  further  study 
of  railroad  accounting  is  advised  to  obtain  a  list  of  the 
various  documents,  bulletins,  and  rulings  which  have 
been  published  by  the  Interstate  Commerce  Commission. 
Such  a  list  may  be  obtained  from  the  Superintendent  of 
Documents,  Washington,  D.  C. 

TEST  QUESTIONS 

1.  In  a  primitive  situation  where  only  one  proprietorship 
account  is  used,  of  what  distinct  elements  may  its  balance  be 
composed  ? 

2.  What  are  the  elements  of  the  trading  account? 

3.  What  are  the  three  common  forms  of  proprietorship? 

4.  What  are  the  elements  of  a  partnership? 

5.  What  is  the  difference  between  capital  and  capital  stock? 

6.  Make  two  outlines  or  charts  showing  classification  of  pro- 
prietorship accounts. 

7.  What  is  prime  cost? 

8.  What  is  the  difference  between  a  statement  of  profit  and 
loss  and  a  statement  of  receipts  and  disbursements? 


CHAPTER  Vin 

PROPRIETORSHIP-Continued 

The  most  natural  expense  classification  is  according 
to  objects  of  expenditure  (Figure  52),  but  its  usefulness 
is  financial  and  limited  to  judgment  of  the  efficiency  and 
accuracy  of  purchasing.  Such  a  scheme  of  expense 
accounts  furnishes  no  guide  as  to  the  departmental  or 
functional  costs,  no  effective  means  of  control — matters 
of  vital  importance  under  modern  industrial  conditions. 

Very  few  enterprises  employ  this  classification  rig- 
idly— they  modify  and  functionalize  it  to  some  extent. 
Ordinarily  the  segregation  of  expense  is  under  the  gen- 
eral heads  of 

1.  Selling. 

2.  Administration. 

3.  General. 

Each  of  these  may  control  a  group  of  classified  sub- 
accounts.  Thus  postage  occurs  as  a  sales  cost  and  also 
in  the  administration  accounts.  The  reason  is  that  post- 
age used  for  selling  purposes  should  be  kept  distinct  from 
postage  used  for  administrative  purposes.  There  is  no 
more  reason  for  lumping  them  into  one  Postage  Expense 
Account  than  there  is  for  lumping  all  salaries  and  wages 
into  one  Salaries  and  Wages  Account.  It  is  not  particu- 
larly important  to  know  the  total  amount  for  postage  in 
any  one  year,  since  the  figure  by  itself  means  very  little. 

259 


260 


Principles  of  Accounting 


The  postage  should  be  charged  to  the  functions  benefitted 
by  the  postage. 

Then  the  total  of  all  the  expense  accounts  for  a  function 
may  be  compared  with  the  results  which  it  has  achieved. 
Such  information  is  of  the  highest  value.  The  total 
amount  spent  for  wages  and  salaries  is  of  but  mild  inter- 
est, compared  with  the  total  expense  of  a  function  (includ- 
ing salaries  and  wages).  A  profit  and  loss  statement  is 
valuable  in  so  far  as  it  gives  illuminating  information  as 


TREASURER 


1             CREDIT 
BUREAU 

COLLECTION 
1             BUREAU 

PAYMASTER'S 
BUREAU 

CHIEF  CLERK'S      1 
BUREAU            1 

FIG.  67. — Organization  Chart 

to  the  costs  and  results  of  the  various  functions  of  a  busi- 
ness. A  profit  and  loss  statement  giving  purely  statis- 
tical information  such  as  the  total  spent  for  postage,  the 
total  spent  for  wages,  the  total  spent  for  light  and  heat, 
etc.,  is  not  productive  of  efficiency  in  operation,  and  its 
usefulness  is  strictly  limited. 

If  the  plan  of  functional  classification  is  carried  to  its 
logical  conclusion,  as  it  has  been  in  some  of  the  larger 
industrial  and  municipal  units,  the  result  will  be  that  a 
large  number  of  detailed  accounts  will  be  installed  under 
the  general  head  of  Expense.  The  classification  will 
closely  follow  the  organization  plan  of  the  business — first 


^ICJ. 

Till 
rst 


Proprietorship  261 

by  departments   and  then  by  departmental  functions. 
Under  each  function  are  found  the  detail  accounts  for 

Salaries. 
Wages. 

Supplies  Used. 
Maintenance. 
Miscellaneous. 

As  an  example  of  functional  classification,  we  may  con- 
sider  the  case  of  the  treasury  department  of  a  large  busi- 
ness. An  analysis  of  its  organization  might  indicate  the 
existence  of  various  bureaus  or  functions  as  follows  (see 
Figure  67) : 

1.  Credit  Bureau. 

2.  Collection  Bureau. 

3.  Paymasters  Bureau. 

4.  Chief  Clerk. 

(a)  Claim  division. 

(b) .  Bookkeeping  division. 

(c)  Insurance  division. 

Then  for  each  of  these  organization  units  will  appear 
a  set  of  expense  accounts  classified  according  to  objects 
of  expenditure. 

Treasury  Department 

General  Unapportioned  Expense 

Salaries  Account 

Supplies  Used  Account 

Maintenance  Account 

Miscellaneous 
Credit  Bureau  Expense 

Salaries  Account 

Supplies  Used  Account 


262  Principles  of  Accounting 

Agency  Service  Used  Account 
Traveling  Expense  Account 
Maintenance  Account 
Miscellaneous 
Collection  Bureau 
Salaries  Account 
Traveling  Expense  Account 
Supplies  Used  Account 
Maintenance  Account 
Miscellaneous 
Paymaster's  Bureau 
Salaries  Account 
Private  Car  Expense  Account 
Supplies  Used  Account 
Maintenance  Account 
Miscellaneous 
Chief  Clerk's  Bureau 
General  (to  be  apportioned) 

Salaries  Account 

Supplies  Account 

Miscellaneous 
Claim  Division 

Salaries  Account 

Supplies  Used  Account 

Traveling  Expense  Account 

Maintenance  Account 

Apportioned  General  Expense  Account 
Bookkeeping  Division 

Salaries  Account 

Supplies  Used  Account 

Maintenance  Account 

Apportioned  General  Expense  Account 

Miscellaneous 
Insurance  Division 


Proprietorship  263 

Salaries  Account 

Traveling  Expense  Account 

Supplies  Used  Account 

Maintenance  Account 

Apportioned  General  Expense  Acjcormt 

Miscellaneous 

By  proper  combination  of  such  detailed  information 
units  it  is  possible  to  obtain  costs 

1.  For  the  Treasury  Department  as  a  whole. 

2.  For  the  various  functions. 

3.  By  objects  of  expenditure. 

From  accounts  on  this  basis  detailed  functional  reports 
in  comparative  form  may  be  prepared  and  shown  to  the 
bureau  chiefs.  Nothing  brings  efficiency  quite  so  quickly 
as  the  enforcement  of  responsibility  for  results  by  means 
of  prompt  detailed  functional  reports  whose  accuracy  is 
checked  by  general  ledger  control.  This  is  particularly 
true  when  the  figures  can  be  reduced  to  a  "unit-cost" 
basis.  When  each  department,  or  subdepartment,  head 
understands  that  his  performance  is  a  matter  of  record, 
he  has  an  incentive  to  strive  for  larger  results.  The  gen- 
eral plan  of  functional  expense  classification  will  be 
observed  in  Figure  68. 

GENERAL  LEDGER  CONTROL 

Of  course,  all  these  detailed  accounts  will  not  appear 
in  the  General  Ledger.  Instead  they  will  be  kept  in  sub- 
sidiary ledgers  controlled  by  general  ledger  accounts. 
Thus,  in  the  foregoing  example,  the  general  ledger  con- 
trol might  be  the  Treasury  Department  Expense  Account, 
all  the  subordinate  accounts  being  kept  in  a  Treasury 
Department  Expense  Ledger. 


264 


Principles  of  Accounting 


23)1          231          23          I 


0© 

mrffn 


PIG.  68. — Chart  Illustrating  Functional  Classification  of  Accounts 


Proprietorship  265 

Or  the  General  Ledger  might  contain  the  following 
accounts : 

Treasury  Department  Unapportioned  Expense. 
Credit  Bureau  Expense. 
Collection  Bureau  Expense. 
Paymaster's  Bureau  Expense. 
Chief  Clerk's  Bureau  Expense. 

Each  of  these  would  be  a  controlling  account  over  a 
subsidiary  ledger.  As  a  matter  of  fact,  each  summary 
heading  is  in  the  nature  of  a  control  over  the  details  com- 
posing it. 

In  spite  of  this  seeming  complexity  no  particular  diffi- 
culty or  additional  labor  is  to  be  feared  in  the  bookkeep- 
ing work.  It  is  as  easy  to  charge  a  detailed  account  as 
a  general  account,  and  the  controlling  account  receives 
its  postings  in  columnar  totals  at  the  end  of  the  period  in 
the  regular  way. 

APPORTIONMENT  ACCOUNTS 

Obviously  some  items  of  expenditure  are  of  such  a 
nature  that  they  cannot  be  charged  direct  to  a  detailed 
account.  Where  an  employee  divides  his  time  between 
two  or  more  functions,  it  has  been  found  best  to  charge 
his  salary  to  a  departmental  apportionment  account  and 
then  distribute  it,  at  the  end  of  the  period,  to  the  various 
subaccounts.  The  basis  of  distribution  might  be  arbi- 
trary or  determined  from  his  Time  Eeport,  showing  the 
time  he  spent  working  for  the  various  functions.  An  illus- 
tration of  such  an  item  is  the  chief  clerk's  salary  in  the 
classification  illustrated.  It  might  be  charged  to  the  first 
account  under  "General  (to  be  apportioned)"  and  later 
distributed  over  the  Claim,  Bookkeeping,  and  Insurance 


266  Principles  of  Accounting 

divisions  in  proportion  to  the  amount  of  time  he  spent 
with  each. 

Whether  such  items  are  to  be  distributed  or  left  unap- 
portioned  is  a  matter  of  policy.  In  some  cases  it  pays  to 
make  accurate  apportionments,  and  in  others  it  is  unnec- 
essary. 

TKEATMENT  OF  SUPPLIES 

The  charges  for  supplies  may  be  made  from  the  requisi- 
tions themselves  or  from  the  storekeeper's  periodical 
Recapitulation  of  Requisitions.  Where  the  ultimate 
destination  of  the  supplies  is  not  known,  they  may  be  tem- 
porarily charged  to  the  departmental  stores'  accounts 
and  later  charged  out  to  the  functional  accounts. 


The  introduction  of  a  detailed  classification  of  accounts 
in  an  organization  presupposes  the  existence  of  a  thor- 
oughly worked-out  plan  of  organization.  You  cannot 
departmentalize  your  accounts  without  first  departmen- 
talizing the  organization.  Many  organizations  are  so 
loosely  knit  together,  with  lines  of  control  so  vague  and 
poorly  defined,  that  responsibility  can  hardly  be  deter- 
mined. If  a  properly  planned  organization  is  assumed, 
the  accounting  system  may  be  designed  to  fit  it  and  give 
invaluable  information  to  the  administrator. 

A  complex  set  of  classified  accounts  almost  demands  the 
use  of  account  numbers.  There  are  several  account- 
numbering  schemes  in  common  use,  and  any  of  them  may 
be  profitably  employed  even  in  a  moderately  small  organ- 
ization. The  use  of  numbers  instead  of  account  names 
is  a  time-saver  and  is  almost  essential  in  the  larger 
organization. 


Proprietorship  267 

CLEABING  ACCOUNTS 

When  the  various  functions  of  a  business  are  properly 
recognized  in  its  profit  and  loss  statement,  it  is  clear  that 
certain  classes  of  expenditure  such  as  postage,  light  and 
heat,  janitor  service,  power,  etc.,  must  be  distributed 
equitably  among  the  various  departments  or  functions  to 
which  they  are  properly  chargeable.  Charges  may  be 
made  direct  to  the  departmental  or  functional  expense 
accounts,  or  they  may  first  be  charged  to  the  clearing 
accounts  and  then  distributed  to  the  various  depart- 
mental accounts.  Either  method  is  proper,  and  individ- 
ual circumstances  will  indicate  which  one  will  be  used. 

For  an  illustration  of  a  clearing  account,  let  us  assume 
that  the  total  expense  for  electric  light  during  a  given 
accounting  period  was  $2,000.00.  The  various  charges 
making  up  this  total  would  be  debited  to  an  expense 
account  entitled  "Electric  Light  Used."  If  the  business 
has  five  departments,  one  of  which  used  one-half  of  the 
total  light  and  the  other  four  one-eighth  each : 

Department  A  uses  %  total  light 

Department  B  uses  %  total  light 

Department   C  uses  ys  total  light 

Department  D  uses  %  total  light 

Department  E  uses  %  total  light 

the  distribution  of  the  entire  $2,000.00  would  be  made 
as  follows: 

Department  A  chargeable  with  %  of  $2,000.00 $1,000.00 

Department  B  chargeable  with  %  of    2,000.00 250.00 

Department  C  chargeable  with  %  of    2,000.00 250.00 

Department  D  chargeable  with  %  of    2,000.00 250.00 

Department  E  chargeable  with  %  of    2,000.00 250.00 

$2,000.00 


268 


Principles  of  Accounting 


The  proper  method  of  making  this  distribution  in  the 
books  is  by  means  of  the  following  journal  entry : 

Electric  Light  Used— Department  A $1,000.00 

Electric  Light  Used — Department  B 250.00 

Electric  Light  Used— Department  C 250.00 

Electric  Light  Used — Department  D 250.00 

Electric  Light  Used— Department  E 250.00 

Electric  Light  Used  (clearing  account) $2,000.00 

(Note: — In  this  journal  entry  there  is  only  one  credit  item  shown.  It 
is  often  customary  to  post  such  a  credit  as  this  in  five  items  in  order  that 
the  clearing  account  will  be  self-explanatory.  Such  a  posting  is  shown  in 
the  accompanying  ledger  accounts.) 

ELECTRIC  LIGHT  USED  (CLEARING  ACCOUNT) 


Aggregate  charges  for  pe- 
riod     $2,000.00 


$2,000.00 


Department  A (a) 

Department  B (b) 

Department  C (c) 

Department  D (d) 

Department  E (e) 


$1,000.00 
250.00 
250.00 
250.00 
250.00 

$2,000.00 


ELECTRIC  LIGHT  USED — DEPARTMENT  A 


Clearing  Account (a)   $1,000.00 


ELECTRIC  LIGHT  USED — DEPARTMENT  B 


Clearing  Account (b)   $250.00 


ELECTRIC  LIGHT  USED — DEPARTMENT  C 


Clearing   Account (c)   $250.00 


Proprietorship  269 

ELECTRIC  LIGHT  USED — DEPARTMENT  D 


Clearing  Account (d)   $250.00 


ELECTRIC  LIGHT  USED — DEPARTMENT  E 


Clearing  Account (e)   $250.00 


BASES  OF  DISTRIBUTION 

Where  a  single  kind  of  expense  is  to  be  distributed 
over  departments  or  functions,  it  is  imperative  that  a 
proper  basis  of  distribution  be  ascertained.  This  is 
sometimes  difficult  to  determine. 

Where  an  electrical  meter  can  be  installed  in  each 
department  to  measure  the  amount  of  current  consumed, 
the  distribution  of  electric  light  charges  is  based  on  the 
proportion  between  the  total  electricity  consumed  by  any 
one  department  and  the  total  electricity  consumed  by  the 
entire  establishment.  Often  it  is  impossible  or  inex- 
pedient to  adopt  such  a  method,  and  some  other  basis 
must  be  sought.  One  that  is  frequently  used  is  the  pro- 
portion between  the  total  candle  power  of  lamps  in  the 
department  and  the  total  candle  power  of  all  lamps  in  the 
•establishment.  Thus,  if  the  latter  figure  were  500  and 
the  total  candle  power  of  all  lamps  in  Department  B  were 
250,  then  Department  B  would  be  chargeable  with  one- 
half  of  the  electric  light  expense.  This  basis,  while  fairly 
satisfactory,  is  not  necessarily  accurate,  since  some  kinds 
of  lamps  consume  more  electricity  per  candle  power  than 
others. 

Another  basis  of  distribution  may  be  that  of  the  "test- 
run.  ' '  If  an  accurate  test  of  the  total  current  consumed 
by  a  given  department  is  made  covering  a  sufficient  period 


270  Principles  of  Accounting 

of  time,  a  figure  may  be  obtained  that  can  be  used  as  a 
basis  for  future  distributions. 

It  is  customary  to  distribute  heating  expense  over 
departments  according  to  the  cubic  feet  of  space  they 
occupy,  since  it  has  been  found  by  experiment  that  a  room 
uses  heat  in  proportion  to  its  cubic  contents.  If  steam 
heat  is  used,  the  basis  of  distribution  might  be  the  num- 
ber of  square  inches  of  radiating  surface  in  a  given 
department  as  compared  with  the  total  number  of  square 
inches  of  radiating  surface  in  the  entire  establishment 

Power  is  distributable  by  meter  or  by  test.  It  is  usu- 
ally necessary  to  make  a  series  of  "  test-runs "  in  order 
to  determine  the  proportion  of  power  which  each  depart- 
ment consumes.  Power  may  be  distributed  on  a  basis  of 
the  total  horse  power  requirements  of  the  machines  in 
each  department,  or  where  electric  power  and  individual 
motors  are  used,  the  power  may  be  metered  and  a  very 
accurate  distribution  obtained. 

Distribution  of  postage  expense  involves  difficulties. 
Where  a  central  mailing-room  is  used,  the  distribution 
may  be  on  the  basis  of  daily  or  weekly  reports  by  the 
mailing  clerk.  It  is  usually  rather  difficult  to  make  a 
fair  distribution  of  this  item  of  expense  except  in  a 
business  where  a  large  amount  of  postage  is  used.  In 
the  average  office  it  is  probably  sufficient  to  make  a  '  '  test- 
run"  covering  a  period  of  a  few  weeks,  utilizing  the 
proportion  thus  obtained  as  standard. 

The  danger  of  establishing  such  a  standard  basis  is 
that  conditions  may  change.  When  the  "  test-run " 
method  of  ascertaining  bases  of  distribution  is  in  use, 
it  is  essential  that  the  test  be  repeated  periodically  to 
find  whether  the  ratio  has  remained  constant. 

It  is  impossible  to  treat  the  subject  of  apportionment 
very  fully,  because  many  of  its  problems  need  to  be  solved 


Proprietorship  271 

anew  for  each  organization.  No  one  method  is  accurate 
in  every  case.  Apportionment  should  always  be  made, 
based  on  actual  facts;  and  on  this  basis  there  are  many 
methods  for  different  kinds  of  expense.  Under  normal 
circumstances  nearly  every  expense  item  can  be  dis- 
tributed departmentally  on  one  of  the  following  bases : 

Number  of  square  feet  (rent) 
Number  of  cubic  feet  (heat) 
Number  of  sales  slips  (waiting  room) 
Number  of  square  inches  (advertising  space) 
Number  of  items  delivered  (delivery  expense) 
Value  of  supplies  used  (stores  expense) 
Number  of  bills  entered  (billing  expense) 

but  special  bases  can  often  be  determined  that  will  fit 
individual  cases  better. 

In  railroad  work  special  bases  of  apportionment  are 
used  in  connection  with  various  attempts  to  obtain  the 
cost  of  passenger  service  and  freight  service  separately, 
such  as 

Eevenue  train-miles. 
Ton-miles. 
Car-miles. 
Gross  earnings. 
Train-hours,  etc. 

As  an  example  of  the  use  of  clearing  accounts,  the  item 
of  power,  $2,100.00,  appearing  on  the  profit  and  loss 
statement  in  Figure  58  may  be  discussed.  Where  pur- 
chases of  power  are  made  from  an  independent  utility, 
the  monthly  power  bills  may  be  charged  direct  to  a  power 
expense  account,  but  where  a  concern  manufactures  its 
own  power,  a  very  different  situation  develops.  The 
production  of  power  is  a  function  separate  and  distinct 


272  Principles  of  Accounting 

from  manufacturing  or  selling.  An  industry  which 
manufactures  its  own  power  is  in  the  power  business, 
•although  it  has  only  one  customer,  i.  e.,  itself. 

An  industry  manufacturing  its  own  power  must  deter- 
mine through  a  properly  classified  set  of  expense  accounts 
the  total  cost  of  all  power  produced  during  the  accounting 
period.  If  all  the  power  thus  generated  is  used  in  the 
factory  for  machine  operation,  the  problem  is  compara- 
tively a  simple  one;  but  where  it  is  also  used  for  the 
purpose  of  supplying  electricity  and  heat,  the  figure  rep- 
resenting total  cost  of  power  must  be  distributed  so  as 
to  arrive  at  the  cost  of  lighting  and  heating  and  the  cost 
of  power  consumed  in  the  factory.  The  figure  represent- 
ing "light  and  heat"  will  then  have  to  be  redistributed 
over  the  various  departments. 

Let  us  assume  that  the  books  of  the  Blank  Company 
show  the  following  power  accounts: 

Coal  Used $3,150.00 

Water    Used 250.00 

Supplies    Used 300.00 

Wages 1,200.00 

Salaries    1,500.00 

Depreciation   of   Buildings 350.00 

Repairs  to  Buildings 50.00 

Depreciation   of  Equipment 400.00 

Repairs  to  Equipment 100.00 

$7,300.00 

The  total  of  these  figures  is  $7,300.00  and  represents 
the  cost  of  power  production.  At  the  end  of  the  account- 
ing period  the  balances  of  these  accounts  will  be  trans- 
ferred by  journal  entries  to  a  clearing  account  entitled 
"Cost  of  Power  Production."  It  is  now  necessary  to 
•distribute  this  figure  of  $7,300.00  over  two  other  accounts : 


Proprietorship 


273 


IL 


7  3 


0-m 


e 


U 


FIG.  69. — General  Ledger  Clearing  Accounts 


274  Principles  of  Accounting 

1.  Power  Used  by  Factory. 

2.  Light  and  Heat — General. 

We  may  assume  that  the  basis  of  distribution  used  is 
such  that  the  Light  and  Heat  is  chargeable  with  $5,200.00 
and  Power  Used  by  Factory  is  chargeable  with  $2,100.00. 

Dec.  31     Light  and  Heat— General $5,200.00 

Power  Used  by  Factory 2,100.00 

Cost  of  Power  Production $7,300,00 

The  account,  which  we  have  called  "  Light  and  Heat — 
General,"  is  also  a  clearing  account,  and  its  total  must 
be  distributed  over  the  factory,  the  sales  department, 
the  advertising  department,  and  the  general  offices. 
Figure  69  shows  the  various  accounts  concerned  in  this 
procedure. 

It  will  be  noted  that  the  original  power  expense 
accounts  were  all  closed  into  Cost  of  Power  Production 
and  that  this  total  was  then  distributed  into  two  other 
accounts,  thus  closing  the  Cost  of  Power  Production,  and 
that  the  Light  and  Heat  also  is  closed,  its  total  being 
distributed  to  the  four  departmental  accounts.  See 
Figure  69  in  connection  with  the  profit  and  loss  statement 
shown  in  Figure  55. 

TEST  QTJESTIONS 

1.  (a)  What  two  general  plans  of  proprietorship  account 
classification  are  in  general  use? 

(b)  What  are  the  characteristics  of  each? 

2.  Construct  an  organization  chart  for  a  business  or  a  de- 
partment and  design  an  appropriate  expense  account  classifica- 
tion to  fit  it. 

3.  (a)  What  are  departmental  apportionment  accounts? 
(b)  How  are  they  used? 

4.  What  are  the  advantages  of  using  account  numbers? 


CHAPTER  IX 

PARTNERSHIP 

The  problems  connected  with  partnership  accounting  * 
vary  but  little  from  the  general  accounting  principles 
which  we  have  heretofore  discussed.  The  principal 
sources  of  difficulty  in  partnership  accounting  refer  to 
the  partnership  relation,  i.  e.,  the  formation  of  the  part- 
nership— disposition  of  profits  and  losses — dissolution 
of  the  partnership.  The  first  point  which  should  be 
emphasized  is  that,  in  a  properly  organized  partnership, 
the  relation  of  the  partners  one  to  another,  and  to  the 

1  On  page  218  in  Chapter  VII  was  outlined  a  general  classification  of 
proprietorship  accounts,  and  the  statement  was  made  that  partnership 
accounting,  as  commonly  practiced,  was  not  in  entire  harmony  with  correct 
principles.  It  is  generally  conceded  that  investments  in  a  business  should 
be  booked  separately  from  the  subsequent  accumulation  of  losses  or  undi- 
vided profits  due  to  operation.  It  is  exceedingly  desirable  to  know  the 
original  investment,  and  this  may  be  difficult  to  determine  if  the  investment 
account  also  receives  the  entries  for  profits  and  losses.  On  this  account  the 
use  of  a  Surplus  Account  has  been  recommended. 

Another  point  of  somewhat  less  importance  is  the  use  of  a  Profit  and 
Loss  Allocation  Account,  whose  sole  function  is  that  of  a  distribution  account 
for  the  net  loss  or  gain  of  a  period. 

In  partnership  bookkeeping  both  these  points  are  habitually  ignored. 
It  is  common  practice  to  distribute  profits  or  losses  to  the  partners'  capital 
accounts.  Thus  the  partners'  investments  in  the  business  may  be  changed 
at  the  close  of  every  fiscal  period  and  the  amount  of  the  original  investments 
lost  sight  of. 

Few,  if  any,  partnerships  distribute  net  profits  or  loss  through  a  Profit 
and  Loss  Allocation  Account.  Bather  they  distribute  directly  from  the  Profit 
and  Loss  Account  itself.  While  this  is  a  'rather  minor  point  of  technique,  ft 
is  essential  that  it  be  kept  in  mind  when  discussing  or  solving  partnership 
problems. 

275 


276  Principles  of  Accounting 

business,  is  governed  absolutely  by  the  terms  of  the 
articles  of  partnership.  This  document  should  cover  all 
the  important  contingencies  which  may  cause  internal 
disputes  among  the  partners. 

ARTICLES  OF  PARTNERSHIP 

A  properly  drawn-up  agreement  should  contain  at  least 
the  following  clauses: 

1.  Name  and  location  of  the  business,  nature  of  the 
business. 

2.  Life  of  the  partnership. 

3.  Duties  and  power  of  each  partner. 

4.  Capital  contribution — if  made  in  property  other 
than  cash,  the  basis  of  valuation  should  be  stated. 

5.  Interest  on  capital,  on  loans,  on  excess  or  defi- 
ciencies of  capital. 

6.  Withdrawals  of  profit. 

7.  Apportionment  of  profits  and  losses. 

8.  Salaries  of  partners. 

9.  Keeping  of  partnership  accounts. 

10.  Provision  for  unforeseen  termination  of  partner- 
ship. 

When  articles  of  partnership  are  properly  drawn,  the 
problems  connected  with  partnership  accounting  are 
much  simplified ;  but  it  is  very  often  that  the  agreement 
is  verbal  or,  at  least,  indefinitely  stated  in  writing. 

The  articles  should  unquestionably  specify  how  profits 
and  losses  are  to  be  apportioned.  They  may  or  may 
not  be  distributed  among  the  partners  in  the  same  ratio 
as  capital  contributed.  Capital  may  be  contributed 
according  to  one  ratio,  profits  may  be  distributable 
according  to  another,  and  losses  according  to  still  a  third, 
all  depending  upon  the  terms  of  the  partnership  agree- 


Partnership  277 

ment.  In  the  lack  of  a  partnership  agreement  the  rule 
of  law  is  that  profits  and  losses  are  to  be  shared  equally 
by  the  partners,  regardless  of  their  capital  investment. 
Where  the  partnership  agreement  specifies  how  profits 
should  be  divided  but  does  not  mention  the  disposition 
of  losses,  it  is  assumed  that  the  same  ratio  will  apply. 

It  very  often  happens  in  the  formation  of  a  partnership 
that  partnership  contributions  are  not  always  in  cash. 
When  other  assets  or  services  are  accepted  in  lieu  of 
cash,  their  value  should  be  determined  once  for  all. 
After  they  have  once  been  accepted,  any  losses  in  the 
value  of  such  assets  must  be  borne,  not  by  the  contribut- 
ing partner,  but  by  all  the  partners  in  accordance  with 
the  agreed-upon  ratio  of  profit  and  loss  sharing. 

Very  often  a  partner  contributes  certain  assets  for  the 
use  of  the  partnership,  but  which  still  remain  his  exclu- 
sive property.  Such  assets  should  not  be  booked  as 
partnership  resources.  Upon  dissolution  such  assets 
belong  to  the  partner  who  has  loaned  them. 

JUNIOR  PARTNERS 

In  certain  of  the  larger  partnership  organizations,  such 
as  legal  firms,  stock  and  bond  houses,  private  bankers, 
etc.,  it  is  customary  to  take  promising  young  men  as 
junior  partners.  The  arrangement  is  usually  one 
whereby  the  incoming  junior  partner  is  promised  a  share 
in  the  profits  only.  He  may  or  may  not  share  in  the 
losses.  The  arrangement  is  ordinarily  revocable  by  the 
senior  partner  at  any  time,  or  at  the  expiration  of  a 
stated  period.  From  the  internal  point  of  view  such  an 
arrangement  is,  in  reality,  nothing  more  than  a  special 
contract  of  employment,  but,  in  the  case  of  proceedings 
by  creditors,  it  may  result  in  an  actual  legal  partnership. 


278 


Principles  of  Accounting 


This  would  be  a  matter  for  the  courts  to  determine.  On 
the  partnership  books  the  arrangement  may  be  considered 
as  a  special  profit-sharing  employment  contract  and  the 
junior  partner  as  an  employee. 

FORMATION  OF  A  PARTNERSHIP 

A  careful  distinction  should  be  made  in  the  case  of  an 
incoming  partner  as  to  whether  he  purchases  a  share  of 
the  profits  of  the  business  or  an  interest  in  the  business. 
Suppose  that  the  balance  sheet  of  A.  A.  Ames  appeared 
as  follows: 

BALANCE  SHEET 


Merchandise  Inventory. .  .$25,000.00      Ames— Capital  Account..  .$25,000.00 


He  may  admit  Brown  to  partnership  if  he  contributes 
$20,000.00  in  cash,  and  the  partnership  agreement  may 
specify  that  profits  and  losses  are  to  be  divided  equally, 
in  spite  of  the  fact  that  one  partner  has  invested 
$25,000.00  and  the  other  only  $20,000.00. 

If  Brown  had  bought  a  one-half  interest  in  the  business 
with  his  $20,000.00,  the  balance  sheet  would  appear  as 
follows : 

BALANCE  SHEET 


Merchandise  Inventory. .  .$25,000.00 
Cash    20,000.00 


$45,000.00 


Ames — Capital  Account. . .  $22,500.00 
Brown — Capital  Account..   22,500.00 


$45,000.00 


An  alternative  arrangement  would  have  scaled  down 
the  value  of  merchandise  to  $20,000.00,  thus  cutting  Ames' 
Capital  Account  to  the  same  figure  in  the  following 
balance  sheet: 


Partnership 
BALANCE  SHEET 


279 


Merchandise $20,000.00 

Cash    20,000.00 


$40,000.00 


Ames — Capital  Account. . .  $20,000.00 
Brown— Capital  Account..   20,000.00 


$40,000.00 


If  instead  of  $20,000.00  Brown  had  paid  $30,000.00  for 
a  half  interest  in  the  business,  it  would  be  assumed  that 
the  $5,000.00  premium  which  he  paid  was  due  to  Goodwill, 
which  was  really  one  of  Ames'  assets,  although  not 
actually  shown  on  his  books. 

BALANCE  SHEET 


Merchandise $25,000.00 

Cash     30,000.00 

Goodwill 5,000.00 


$60,000.00 


Ames — Capital    Account . .  $30,000.00 
Brown— Capital  Account..   30,000.00 


$60,000.00 


As  alternative  to  the  foregoing  arrangement  the  fol- 
lowing would  be  proper : 


BALANCE  SHEET 


Merchandise $25,000.00 

Cash    30,000.00 


$55,000.00 


Ames— Capital    Account . .  $27,500.00 
Brown— Capital  Account..   27,500.00 


$55,000.00 


If  a  partnership  is  already  established  one  partner  may, 
with  the  consent  of  the  other,  dispose  of  part  of  his 
interest  to  an  outsider  without  any  new  capital  being 
brought  into  the  business.  Assume  a  partnership  with 
the  following  balance  sheet: 


280 


Principles  of  Accounting 
BALANCE  SHEET 


,$60,000.00 


$60,000.00 


Ames — Capital    Account . .  $30,000.00 
Brown — Capital    Account.   30,000.00 


$60,000.00 


If  Ames  sold  half  of  his  interest  to  Clark,  the  balance 
sheet  might  reflect  the  fact  as  follows : 


BALANCE  SHEET 


Assets 


,$60,000.00 


$60,000.00 


Ames — Capital  Account .  .  $15,000.00 
Brown — Capital  Account..  30,000.00 
Clark — Capital  Account...  15,000.00 


$60,000.00 


You  should  note  that  the  deal  between  Ames  and  Clark 
is  purely  a  private  one,  and  from  the  books  of  the  part- 
nership it  would  be  impossible  to  tell  how  much  Clark 
had  paid  Ames  for  half  of  his  interest.  He  might  have 
paid  him  $20,000.00,  or  the  purchase  price  might  have 
been  only  $10,000.00. 

The  status  of  the  assets  is  not  altered  in  the  least  by 
such  an  arrangement,  but  if  Clark  had  contributed 
$15,000.00  to  the  partnership  for  a  one-fifth  interest  in 
the  business,  the  assets  would  be  increased  $75,000.00, 
and  an  additional  $15,000.00  of  capital  registered  on  the 
books,  as  seen  in  the  following  illustration: 

BALANCE  SHEET 


Assets    $75,000.00 


$75,000.00 


Ames — Capital  Account..  .$30,000.00 
Brown — Capital  Account..  30,000.00 
Clark — Capital  Account.. .  15,000.00 


$75,000.00 


Partnership  281 

The  foregoing  set  of  examples  illustrates  the  funda- 
mental importance  of  clearly  determining  whether  an 
incoming  partner  purchases  an  interest  in  the  profits 
or  an  interest  in  the  business. 

INTEREST  ON  CAPITAL 

Very  often  the  partnership  agreement  specifies  that 
interest  is  to  he  paid  to  the  partners  according  to  an 
agreed  percentage  upon  the  capital  invested.  When  one 
partner  contributes  more  capital  than  another  and  the 
partnership  agreement  provides  that  profits  are  to  be 
shared  equally,  it  is  clear  that  the  partner  with  the  least 
investment  is  obtaining  larger  returns  on  his  capital 
than  the  other.  Under  such  circumstances,  therefore, 
it  is  often  customary  to  provide  that  6%  interest  be 
allowed  on  capital  contributions  before  profits  are  divided. 
Such  interest  is  not  an  expense  to  the  business  and  should 
not  be  charged  to  the  regular  interest  account.  A  special 
account  for  this  purpose  should  be  set  up  entitled  "Inter- 
est on  Capital  Invested, ' '  and  its  debit  balance  should  be 
deducted  from  the  net  profits  for  the  period.  When  the 
interest  is  charged  to  this  account,  it  should  be  credited 
to  the  individual  partners '  capital  accounts. 

In  illustration  of  these  points  the  following  transactions 
may  be  noted : 

AMES — CAPITAL  ACCOUNT 


Invested $30,000.00 


BROWN — CAPITAL  ACCOUNT 


Invested $30,000.00 


282 


Principles  of  Accounting 

CLARK — CAPITAL  ACCOUNT 


Invested $15,000.00 


At  the  end  of  the  year,  if  interest  at  6%  is  allowed 
on  the  capital  invested,  Ames  and  Brown  will  be  credited 
with  $1,800.00  each  and  Clark  will  be  credited  with 
$900.00,  the  total  $4,500.00  being  charged  to  Interest  on 
Capital  Invested.  Since  all  profits  and  losses  are  to  be 
divided  equally  among  the  partners,  each  partner  would 
then  be  charged  with  one-third  of  this  $4,500.00,  thus 
balancing  the  interest  account,  and  when  the  entries  have 
been  made,  their  capital  accounts  may  appear  as  follows : 

AMES — CAPITAL  ACCOUNT 


ys  Interest $1,500.00 


Investment   $30,000.00 

Interest 1,800.00 


BROWN — CAPITAL  ACCOUNT 


Interest $1,500.00 


Investment 
Interest  . 


,$30,000.00 
,     1,800.00 


CLARK — CAPITAL  ACCOUNT 


ys  Interest  

$1,500.00 

Investment 

$15  000  00 

Interest 

90000 

The  same  result  could  have  been  obtained  without  the 
necessity  of  passing  the  items  through  a  special  Interest 
Account.  Ames'  and  Brown's  Capital  Accounts  could 
have  been  credited  with  $300.00  each,  and  Clark's  Capital 
Account  could  have  been  charged  with  $600.00,  thus 
obtaining  exactly  the  same  result. 


Partnership  283 

Clark's  Capital  Account $600.00 

Ames '  Capital  Account $300.00 

Brown 's   Capital  Account 300.00 

AMES — CAPITAL  ACCOUNT 


Investment   $30,000.00 

Interest   .  300.00 


BROWN — CAPITAL  ACCOUNT 


Investment  $30,000.00 

Interest   .  300.00 


CLARK — CAPITAL  ACCOUNT 


Interest    $600.00      Investment   : $15,000.00 


Where  the  partnership  agreement  specifies  that  inter- 
est is  to  be  charged  on  deficits  and  credited  for  excess 
of  required  capital  contributions,  a  somewhat  different 
problem  is  presented.  If  a  partner's  nominal  contribu- 
tion is  $10,000.00  and  he  has  actually  contributed  only 
$8,000.00,  his  deficit  is  $2,000.00,  and  since  the  profit  and 
loss  sharing  ratio  is  determined  after  taking  the  nominal 
capital  contributions  into  consideration,  it  is  only  fair 
that  the  partner  who  has  not  actually  contributed  the  full 
amount  should  pay  interest  on  the  deficit.  Similarly,  a 
partner  who  has  actually  contributed  $12,000.00  when  he 
is  only  required  to  contribute  $10,000.00  is  clearly  entitled 
to  interest  on  the  excess  investment.  Such  items  of 
interest  should  be  passed  through  the  regular  interest 
account,  since  such  excesses  and  deficits  are  in  the  nature 
of  loans  to  the  partnership  or  loans  by  the  partnership, 


284  Principles  of  Accounting 

i.  e.,  accounts  payable  or  accounts  receivable.  Interest 
on  such  items  should  be  treated  the  same  way  as  interest 
on  any  loan. 

LIQUIDATION  OF  PARTNERSHIP 

A  great  deal  of  misconception  exists  regarding  the 
accounting  features  of  partnership  dissolutions.  If  the 
profit  and  loss  sharing  ratio  is  known,  the  problem  is  a 
simple  one.  Suppose  that  the  firm  of  Ames  and  Brown, 
sharing  profits  and  losses  in  the  ratio  of  %  and  Yz 
respectively,  find  that  their  venture  is  unprofitable  and 
their  capital  impaired.  They  decide  to  discontinue  busi- 
ness and  distribute  the  remaining  assets. 

BALANCE  SHEET — AMES  &  BROWN 


Assets  (cash  value) $37,000.00 

Deficit  33,000.00 


$70,000.00 


Ames — Investment    $45,000.00 

Brown— Investment    25,000.00 


$70,000.00 


How  should  the  $37,000.00  of  cash  assets  be  divided? 
Some  might  assume  that  45/70  of  the  assets  ($23,785.70) 
would  go  to  Ames  and  25/70  ($13,214.30)  to  Brown,  but 
this  would  be  absolutely  wrong.  The  partnership  agree- 
ment specifies  that  profits  and  losses  are  to  be  shared, 
y$  by  Ames  and  y$  by  Brown,  and  this  ratio  is  different 
from  the  capital  ratio.  Since  the  loss  of  $33,000.00  must 
be  charged  to  the  partners  in  the  ratio  of  %  to  J3,  Ames 
will  be  charged  with  $22,000.00  and  Brown  with  $11,000.00. 

JOURNAL  ENTRY 

Ames*  Capital  Account $22,000.00 

Brown 's  Capital  Account 11,000.00 

Deficit  Account $33,000.( 


Partnership 

AMES — CAPITAL  ACCOUNT 


285 


Loss  (%  of  $33,000) $22,000.00 

Balance   (in  red) 23,000.00 


Investment  $45,000.00 


$45,000.00 

Balance 

BROWN — CAPITAL  ACCOUNT 


$45,000.00 
,$23,000.00 


Loss  0/3  of  $33,000.00).. $11,000.00 
Balance   (in  red) 14,000.00 


Investment    $25,000.0(v 


$25,000.00 

Balance 

BALANCE  SHEET — AMES  &  BROWN 


$25,000.00 
,$14,000.0(. 


Assets  (Cash  Value)  .  . 

.  .  .$37,000.00 

Ames  —  Capital  Account.  . 

.$23,000.00 

Brown  —  Capital  Account. 

.   14,000.00 

$37,000.00 

$37,000.00 

The  loss  having  been  charged  to  the  partners'  capital 
accounts,  the  total  assets  equal  the  total  proprietorship 
interest,  and  Ames  will  get  $23,000.00  and  Brown 
$14,000.00. 

In  some  cases  such  a  distribution  of  losses  will  more 
than  extinguish  one  partner 's  capital  account,  leaving  him 
in  debt  to  the  other  partners.  This  amount  will  be  set 
up  on  the  partnership  books  as  an  asset.  If  collected,  it 
will  be  divided  among  the  remaining  partners.  If  uncol- 
lectible it  will  be  treated  like  any  other  bad  debt — a  loss 
to  be  borne  by  the  remaining  partners.  For  illustration 
we  may  consider  the  case  of  three  partners  who  share 
profits  and  losses  equally. 


286 


Principles  of  Accounting 

GIBBS,  HALL  &  Co. — BALANCE  SHEET 


Assets  (Cash  Value) $10,000.00       Gibbs— Capital   Account.  .$10,000.00 

Deficit   6,000.00       Hall — Capital    Account...     5,000.00 

Jones — Capital   Account..     1,000.00 

$16,000.00  $16,000.00 

JOURNAL  ENTRY 

Gibbs — Capital    Account $2,000.00 

Hall— Capital  Account 2,000.00 

Jones — Capital    Account 2,000.00 

Deficit    $6,000.00 

Distributing  the  loss  equally  among  the  partners  in 
accordance  with  the  partnership  agreement : 

GIBBS — CAPITAL  ACCOUNT 

Loss  O/g  of  $6,000.00)  . .  .$  2,000.00       Investment   $10,000.00 

Balance  (red) 8,000.00 

$10,000.00  $10,000.00 

Balance $  8,000.00 

HALL — CAPITAL  ACCOUNT 

Loss  0/3  of  $6,000.00) $2,000.00      Investment  $5,000.00 

Balance  (red) 3,000.00 

$5,000.00  $5,000.00 

Balance    $3,000.00 

JONES — CAPITAL  ACCOUNT 

Loss  0/3  of  $6,000.00) $2,000.00      Investment  $1,000.00 

Balance  (red) 1,000.00 

$2,000.00  $2,000.00 

Balance .$1,000.00 


Partnership 


287 


GIBBS-HALL  &  Co. — BALANCE  SHEET 


Assets  (cash  value) $10,000.00 

Jones— Deficit    1,000.00 


$11,000.00 


Gibbs — Capital  Account.. $  8,000.00 
HaU — Capital  Account 3,000.00 


$11,000.00 


If  Jones  makes  up  this  $1,000.00  deficiency,  then  the 
cash  value  of  the  assets  will  he  $11,000.00,  distributable 
$8,000.00  to  Gibbs  and  $3,000.00  to  Hall.  If  Jones  is 
insolvent,  then  the  $1,000.00  he  owes  must  be  considered 
a  loss  and  divided  among  the  remaining  partners  equally 
as  specified  by  the  partnership  agreement.  Each  partner 
will  be  charged  with  $500.00,  and  the  balance  sheet  will 
then  appear  as  follows : 

GIBBS,  HALL  &  Co.— BALANCE  SHEET 


Assets  (cash  value) $10,000.00 


$10,000.00 


Gibbs— Capital   Account.. $  7,500.00 
Hall — Capital    Account...     2,500.00 


$10,000.00 


The  assets  will  then  be  distributed  to  the  partners — 
$7,500.00  to  Gibbs  and  $2,500.00  to  Hall. 

PROBLEM 

(Adapted  from  the  Illinois  C.  P.  A.  Examination, 
November,  1908) 

A,  B,  and  C  were  partners  and  contributed  the  follow- 
ing capital :  A,  $8,000.00 ;  B,  $6,000.00 ;  and  C,  $4,000.00. 
Profits  and  losses  were  to  be  borne  equally.  At  the  end 
of  the  first  year  each  partner  had  drawn  $1,000.00.  The 
assets  were  then  disposed  of  for  $3,000.00,  the  purchaser 
discharging  all  liabilities  of  the  firm.  How  should  this 
$3,000.00  be  apportioned  among  the  partners?  In  your 
solution  assume  that  C  was  insolvent. 


288 


Principles  of  Accounting 


SOLUTION 

After  the  assets  were  sold  the  firm's  condition  was  as 
follows : 

BALANCE  SHEET 


Cash  $  3,000.00 

A 's  drawings 1,000.00 

B  's   drawings 1,000.00 

C  's    drawings 1,000.00 

Deficit    12,000.00 


$18,000.00 


A— Capital  Account $  8,000.00 

B — Capital  Account 6,000.00 

C— Capital  Account 4,000.00 


$18,000.00 


Since  losses  must  be  divided  equally,  each  partner  will 
be  charged  with  yz  of  $12,000.00,  or  $4,000.00,  leaving 
A's  capital  $4,000;  B's  capital  $2,000.00;  and  eliminating 
C  altogether. 


BALANCE  SHEET 


Cash  $3,000.00 

A 's    drawings 1,000.00 

B 's   drawings 1,000.00 

C 's   drawings 1,000.00 


$6,000.00 


A — Capital   Account $4,000.00 

B — Capital  Account 2,000.00 


$6,000.00 


By  the  terms  of  the  problem,  C  is  insolvent  and  cannot 
pay  the  $1,000.00  which  he  owes.  This  amount  is,  there- 
fore, a  further  loss  to  A  and  B  and  must  be  divided 
equally  between  them. 


BALANCE  SHEET 


Cash $3,000.00 

A 's  drawings 1,000.00 

B 's   drawings 1,000.00 

$5,000.00 


A — Capital  Account $3,500.00 

B — Capital  Account 1,500.00 


$5,000.00 


Partnership 


289 


or 

BALANCE  SHEET 


Cash $3,000.00 


$3,000.00 


A— Capital  Account $2,500.00 

B — Capital  Account 500.00 


$3,000.00 


The  two  drawing  accounts  were  assets  of  the  business, 
being  accounts  receivable  against  A  and  B  as  individuals. 
If  A  and  B  had  paid  in  $1,000.00  a  piece  to  settle  these 
debts,  the  balance  sheet  would  have  appeared  as  follows : 


BALANCE  SHEET 


Cash $5,000.00 


$5,000.00 


A — Capital  Account $3,500.00 

B — Capital  Account 1,500.00 

$5,000.00 


Instead  of  paying  the  cash  in  and  then  taking  it  right 
out  again,  a  short  cut  may  be  taken  (as  shown  in  this 
solution),  transferring  the  debit  balances  of  the  drawing 
accounts  to  the  Capital  Account. 

Where  the  ratio  of  invested  capital  is  different  from 
the  profit  and  loss  sharing  ratio  and  it  is  desired  to 
liquidate  the  business  gradually  by  paying  the  partners 
off  in  installments,  there  is  danger  that  unexpected  losses 
during  realization  may  cause  one  of  the  partners  to  be 
overpaid.  Under  such  circumstances  it  is  desirable  to 
pay  the  first  installment  in  such  a  way  as  to  bring  the 
capital  ratio  and  the  profit  and  loss  sharing  ratio  to  the 
same  basis. 

In  illustration  of  this  point,  assume  the  case  of  a 
liquidating  partnership  with  the  following  balance  sheet: 


290 


Principles  of  Accounting 

BALANCE  SHEET — A,  B,  &  C  Co. 


Sundry  Assets. 


,$18,000.00 


$18,000.00 


A — Capital  Account $10,000.00 

B — Capital  Account 5,000.00 

C — Capital  Account 3,000.00 


$18,000.00 


By  the  terms  of  the  partnership  agreement,  all  profits 
and  losses  are  to  be  shared  in  the  following  ratio: 


,8/17 
.5/17 
,4/17 


Bather  than  sacrifice  values  by  a  forced  sale  it  is 
decided  to  liquidate  assets  gradually  and  to  pay  the 
partners  in  installments.  The  total  of  the  first  dividend 
to  partners  is  $5,400.00,  and  the  second  dividend  is  the 
same  amount.  These  amounts  are  distributed  to  the 
partners  on  the  basis  of  their  respective  capital  accounts 
—10/18  to  A,  5/18  to  B,  and  3/18  to  C.  A  loss  of 
$5,185.00  is  then  suffered  and  must  be  divided  among  the 
partners  according  to  the  agreed  profit  and  loss  sharing 
basis,  which  differs  from  the  capital  ratio,  the  result 
being  that  C 's  Capital  Account  shows  a  debit  balance. 

A — CAPITAL  ACCOUNT 


First  Installment,   10/18 

of  $5,400.00 (a)  $3,000.00 

Second  Installment, 

10/18  of  $5,400.00 .  (b)  3,000.00 
Loss,  8/17  of 

$5,185.00  (c)  2,440.00 

Balance 1,560.00 


$10,000.00 


Capital    $10,000.00 


$10,000.00 


Balance ...$  1,560.00 


Partnership 
B — CAPITAL  ACCOUNT 


291 


First  Installment,  5/18 
of    $5,400.00 (a) 

Second    Installment, 
5/18  of  $5,400.00...  (b) 

Loss,  5/17  of 

$5,185.00   ..' (c) 

Balance  . 


Capital $5,000.00 


$1,500.00 
1,500.00 

1,525.00 
475.00 

$5,000.00 

Balance 

C — CAPITAL  ACCOUNT 


$5,000.00 
,$    475.00 


First  Installment,  3/18 
of  $5,400.00 (a) 

Second  Installment, 
3/18  of  $5,400.00...  (b) 

Loss,  4/17  of  $5,185.00  (c) 


Balance 


Capital 
900.00       Balance 

900.00 
1,220.00 

$3,020.00 
.$      20.00 

BALANCE  SHEET 


,$3,000.00 
20.00 


$3,020.00 


Sundry  Assets 

..    ..$2,015.00 

A  —  Capital  Account  .  .  . 

..  .$1,560.00 

C  —  Deficit 

20  00 

B  —  Capital  Account 

.    .      475.00 

$2,035.00 

$2,035.00 

In  order  to  prevent  such  a  situation  it  would  be  better 
so  to  divide  the  first  $5,400.00  as  to  make  the  ratio  of 
capitals  equal  to  the  profit  and  loss  sharing  ratio. 

Total  Capital   $18,000.00 

First  Dividend 5,400.00 


Eemaining  Capital $12,600.00 


292 


Principles  of  Accounting 

$12,600.00 


17 

$12,600.00 

17 

$12,600.00 

17 


X  8  =  $5,929.41  -  A's  new  capital 


X  5  =  $3,705.88  =  B's  new  capital 


X  4  =  $2,964.71  =  C's  new  capital 


By  so  dividing  the  first  dividend  of  $5,400.00  as  to 
bring  A's  balance  to  $5,929.41,  B's  balance  to  $3,705.88, 
and  C's  balance  to  $2,964.71,  the  ratio  of  capitals  becomes 
equal  to  the  profit  and  loss  sharing  ratio. 

In  order  to  do  this  the  first  payment  of  $5,400.00  must 
be  apportioned  as  follows: 

A $4,070.59 

B  1,294.12 

C  35.29 

Total $5,400.00 

The  three  partners'  capital  accounts,  after  having  been 
charged  with  the  two  installments  and  with  the  loss,  will 
appear  as  follows : 

A — CAPITAL  ACCOUNT 


First  Installment  ...  (a)  $  4,070.59 
Balance 5,929.41 


$10,000.00 

Second      Installment, 

8/17  of  $5,400.00. .  (b)  2,541.18 

Loss,  8/17  of  $5,185.00  (c)  2,440.00 

Balance  .  948.23 


$  5,929.41 


Capital $10,000.00 


$10,000.00 
Balance $  5,929.41 


$  5,929.41 
Balance  .  ..$     948.23 


Partnership 

B — CAPITAL  ACCOUNT 


293 


First  Inst 
Balance 

ailment       .  .  fa) 

$1,294.12 
3,705.88 

$5,000.00 

Capital  $5,000.00 

$5,000.00 

Second 
5/17  of 
Loss,  5/17 
Balance 

Installment, 
$5,400.00...  (b) 
of  $5,185.00  (c) 

1,588.23 
1,525.00 
592.65 

Balance  $3,705.88 

$3,705.88 

$3,705.88 

Balance  .                            ..$   592.65 

C — CAPITAL  ACCOUNT 


First  Installment (a)  $     35.29 

Balance  2,964.71 

$3,000.00 


Second    Installment, 

4/17  of  $5,400.00...  (b) 
Loss,  4/17  of  $5,185.00  (c) 
Balance  . 


1,270.59 

1,220.00 

474.12 

$2,964.71 

Balance 
BALANCE  SHEET 


Capital    $3,000.00 


$3,000.00 
Balance $2,964.71 


$2,964.71 
.$   474.12 


Sundry  Assets 

$2  015  00 

A  —  Capital  Account.  .  .  . 

..$   948.23 

B  —  Capital  Account  
C  —  Capital  Account.  .  . 

.  .      592.65 
.  .      474.12 

$2,015.00 

$2,015.00 

By  paying  the  first  installment  in  this  manner  the  ratio 
of  the  capital  accounts  is  made  equal  to  the  profit  and 
loss  sharing  ratio.  Subsequent  installments  are  divided 
8 :5 :4,  and  the  loss  is  apportioned  in  the  same  way. 


294  Principles  of  Accounting 

The  subsequent  distribution  of  assets  is  made  according 
to  the  same  ratio  as  profit  and  loss  sharing,  simply  be- 
cause it  is  also  the  capital  ratio.  No  confusion  regarding 
this  point  should  be  permitted.  Assets  are  divided 
according  to  the  capital  ratio.  Losses  are  divided 
according  to  the  profit  and  loss  sharing  ratio,  but  in  this 
case  the  two  have  been  made  equal. 

TEST  QUESTIONS 

1.  What  are  the  principal  sources  of  difficulty  in  partnership 
accounting  ? 

2.  What  important  clauses  should  be  found  in  properly  con- 
structed articles  of  partnership? 

3.  What  is  the  status  of  a  junior  partner? 

4.  Under  what  circumstances  should  partners  receive  interest 
on  their  investments? 

5.  In  the  absence  of  agreement  how  should  profits  and  losses 
be  shared  by  partners? 

6.  When  the  capital  ratio  differs  from  the  profit  and  loss 
sharing  ratio,  what  precaution  should  be  observed  if  assets  are 
liquidated  and  partners  paid  off  in  installments? 


CHAPTER  X 

CORPORATIONS 

Chief  Justice  Marshall's  often-quoted  definition  of  the 
corporation  as  "an  artificial  being,  invisible,  intangible, 
and  existing  only  in  contemplation  of  law"  is  easily  the 
most  satisfactory  that  has  ever  been  offered.  In  the 
famous  case  of  Dartmouth  College  v.  Woodward,  Chief 
Justice  Marshall  declared  that  "being  the  mere  creature 
of  law,  it  possesses  only  those  properties  which  the 
charter  of  its  creation  confers  upon  it,  either  expressly 
or  as  incidental  to  its  very  existence.  These  are  such 
as  are  best  calculated  to  affect  the  object  for  which  it  was 
created.  Among  the  most  important  are  immortality, 
and,  if  the  expression  may  be  allowed,  individuality; 
properties  by  which  a  perpetual  succession  of  many 
persons  are  considered  as  the  same,  and  may  act  as  a 
single  individual. " 

These  various  individuals  who  own  an  interest  in  the 
corporation  are  known  as  "  stockholders, ' '  and  their 
interest  in  the  corporation  is  evidenced  by  shares  of 
stock.  A  share  of  stock  is  usually  for  a  round  amount, 
i.  e.,  $10.00,  $50.00,  $100.00,  or  $1,000.00.  The  stock- 
holders control  the  corporation  through  a  committee  of 
their  representatives,  called  the  "board  of  directors. " 
The  internal  government  of  the  organization  is  dependent 
upon  a  set  of  rules  known  as  "by-laws,"  which  are 
prepared  and  approved  by  the  stockholders.  The  rela- 
tions of  the  corporation  to  the  outside  world  are  depend- 
ent upon  the  charter  which  has  been  granted  it  by  the 

295 


296 


Principles  of  Accounting 


state.  The  stockholders  or  their  representatives,  the 
board  of  directors,  elect  the  officers  of  the  corporation, 
and  these  officers  appoint  minor  officials,  engage  clerks, 
and  hire  workmen.  The  officers  of  the  corporation  are 
usually : 

1.  President. 

2.  Vice-President. 

3.  Secretary  and  Treasurer. 

And  the  general  plan  of  organization  may  appear  as 
follows : 

CORPORATE  ORGANIZATION 


Stockholders 


Directors 


Officers 


Executive  Committee 


General 

Manager 


The  interest  which  the  stockholders  have  in  the  cor- 
poration is  evidenced  by  stock  certificates,  which  are 
signed  by  the  officers.  Each  certifies  that  the  person  to 

whom  it  is  issued  is  "the  owner  of shares  of  common 

(or  preferred)  stock  of  the Company/' 

CAPITAL  STOCK 

A  corporation  may  have  more  than  one  kind  of  capital 
stock.  Its  various  classes  of  stock  may  differ  one  from 
the  other  in 

1.  Dividend  rate. 

2.  Preference  as  to  dividends  or  assets  or  both. 

3.  Voting  power. 


Corporations  297 

One  class  of  stock  may  call  for  a  certain  definite 
dividend  return,  which  must'be  paid  before  the  holders 
of  other  kinds  of  stock  receive  any  dividends.  Such  a 
stock  is  called  "preferred  stock. "  Ordinary  stock  is 
usually  known  as  "  common  stock. "  A  6%  preferred 
stock  would  be  entitled  to  dividends  of  6%  before  any 
dividends  were  declared  on  the  common  stock,  and  if  the 
preferred  stock  is  cumulative,  the  dividends  are  a  charge 
against  the  profits  of  the  company  and  accumulate  until 
paid.  If  preferred  dividends  are  not  paid  in  any  year, 
the  unpaid  amounts  go  over  and  must  be  satisfied  before 
the  common  stockholders  receive  any  dividends. 

In  case  preferred  stock  is  preferred  as  to  assets,  its 
holders,  in  case  of  dissolution,  are  entitled  to  receive  face 
value  for  their  stock,  after  the  satisfaction  of  general 
liabilities,  before  the  common  stockholders  receive  any- 
thing. 

On  the  corporation 's  own  books  capital  stock  is  always 
shown  *  at  its  par  value,  although  in  the  open  market  it 
may  be  quoted  at  either  more  or  less  than  par.  Stock- 
holders are  entitled  to  receive  nothing  in  dividends  until 
and  unless  dividends  are  declared.  The  declaration  of 
dividends  is  controlled  by  the  board  of  directors,  who 
may  declare  dividends  at  such  times  and  in  such  amounts 
as  they  see  fit,  subject  always  to  the  laws  of  the  state. 
As  soon  as  a  dividend  is  declared,  it  becomes  a  liability 
of  the  corporation,  but  until  that  time  it  should  never  be 
shown  as  a  liability,  even  in  the  case  of  past-due  dividends 
on  cumulative  preferred  stock. 

COBPORATE   BOOKS 

The  corporate  form  of  organization  requires  certain 
books  of  record,  which  are  not  necessary  in  the  partner- 

i  See  footnote  on  page  220. 


298  Principles  of  Accounting 

ship  or  in  sole  proprietorship.  The  books  usually  used 
are: 

1.  Minute  Book. 

2.  Subscription  Ledger. 

3.  Certificate  of  Stock  Book. 

4.  Stock  Ledger. 

5.  Stock  Journal. 

In  the  case  of  large  corporations  there  are  other  records 
of  various  kinds. 

The  Minute  Book  is  a  bound  record  of  what  happened 
during  directors '  and  stockholders '  meetings.  This  book 
is  kept  by  the  secretary  of  the  corporation,  who  is 
responsible  for  its  accuracy.  The  by-laws  usually  pro- 
vide that  the  minutes  must  be  read  to,  and  approved  by, 
the  board  of  directors,  after  which  they  may  not  be 
changed. 

The  Stock  Ledger  is  a  book  containing  the  details  of 
shares  of  stock  held  by  the  stockholders.  In  this  volume 
each  stockholder  has  an  account  (Figure  70),  and  to  his 
account  is  credited  the  number  of  shares  of  stock  which 
he  receives,  and  to  it  is  debited  the  number  of  shares  of 
stock  with  which  he  parts.  The  balance  of  his  account  at 
all  times  represents  an  official  record  of  the  number  of 
shares  of  stock  which  he  owns.  Inasmuch  as  capital 
stock  is  ordinarily  transferable  without  notification  to  the 
corporation,  it  may  very  often  happen  that  details  of  the 
Stock  Ledger  do  not  accord  with  the  truth;  but,  since 
dividends  to  stockholders  are  distributed  in  accordance 
with  this  official  record,  it  is  necessary  for  transfers  of 
stock  to  be  reported  to  the  corporation  if  the  real  holder 
is  to  receive  dividends  to  which  he  is  entitled. 

The  Stock  Ledger  is  controlled  by  the  Capital  Stock 
Account  in  the  General  Ledger.  Transfers  of  shares 


Corporations 


299 


I 


to 


T 


300  Principles  of  Accounting 

from  one  person  to  another  will  not  affect  the  total 
shares  outstanding;  hence  the  general  ledger  controlling 
account  will  ordinarily  record  hut  few  changes. 

In  a  large  corporation  whose  shares  are  traded  in 
extensively,  many  transfers  of  stock  will  have  to  be 
made.  In  such  cases  a  Stock  Journal  may  be  used.  This 
is  merely  a  posting  medium. 

When  a  corporation  is  organized,  it  is  usual  to  solicit 
subscriptions  to  capital  stock.  All  persons  who  subscribe 
for  stock  sign  an  agreement  to  accept  when  issued  and 
to  pay  for  it  duly  as  called  for  by  the  directors  as  a 
statutory  step  in  the  organization.  This  is  a  binding 
contract  and  may  be  recorded  on  the  books  of  the  com- 
pany. Where  a  large  number  of  subscriptions  are  made, 
it  is  customary  to  keep  a  Subscription  Ledger,  which 
contains  an  account  with  each  subscriber.  These  accounts 
are  controlled  by  a  general  ledger  account  entitled 
' l  Subscriptions ' '  ( or  "  Subscribers  " ) . 

The  Stock  Certificate  Book  contains  blank  stock  certifi- 
cates, which  are  filled  in  with  the  proper  figures  and  torn 
out.  Each  stock  certificate  blank  is  attached  to  its  stub, 
very  much  like  the  ordinary  check  book.  The  stub  must 
be  filled  in  with  the  same  data  that  appears  on  the  face 
of  the  stock  certificate,  and  the  stub  remains  as  a  perma- 
nent record  of  the  issuance  of  the  certificate. 

CORPORATION  PROPRIETORSHIP  ACCOUNTS 

The  principal  proprietorship  account  is,  of  course, 
Capital  Stock.  The  balance  of  this  account  represents 
at  all  times  the  total  par  value  of  all  stock  outstanding. 
It  is  a  controlling  account  over  the  Stock  Ledger,  which 
shows  details,  the  Capital  Stock  Account  showing  the 
total.  There  should  be  one  Capital  Stock  Account  for 
each  class  of  stock  outstanding.  A  corporation  having 


Corporations  301 

first  preferred  stock,  second  preferred  stock,  and  common 
stock  outstanding  would  have  three  capital  stock  accounts, 
one  for  each  class. 

When  considering  the  copartnership  we  saw  that  the 
net  profits  for  the  year  were  transferred  direct  to  the 
partners'  capital  accounts.  This  cannot  be  done  in  a 
corporation.  The  balance  of  Capital  Stock  is  fixed, 
unless  changes  occur  in  the  number  of  shares  of  stock 
outstanding.  Net  profits,  therefore,  must  be  transferred 
to  some  account  other  than  the  Capital  Stock  Account. 
Such  an  account  may  be  designated  "Surplus."  If  the 
operations  for  any  year  should  show  a  net  loss,  it  may 
be  charged  to  the  Surplus  Account.  If  the  amount  of 
the  loss  were  greater  than  the  total  balance  to  the  credit 
of  Surplus,  the  excess  would  be  charged  to  an  account 
called  "Deficit."  The  capital  stock  outstanding  plus 
the  surplus,  plus  any  credit  balance  allowed  to  remain  in 
Undivided  Profits  will  be  equal  to  the  net  worth  of  the 
corporation.  Or  the  Capital  Stock  Account  less  the 
deficit,  if  there  be  one,  is  also  equal  to  the  net  worth  of 
the  business. 

Another — an  intermediate — proprietorship  account  is 
often  used,  i.  e.,  Profit  and  Loss  Allocation  Account.  To 
this  account  is  credited  the  total  net  profits  for  the  year, 
and  to  it  is  debited  all  withdrawals  of  profits  in  the  shape 
of  dividends.  The  balance  of  the  account  should  be 
closed  into  Surplus  or  Undivided  Profits. 

RESERVES 

As  will  be  discussed  in  a  later  chapter,  dividends  may 
only  be  declared  out  of  the  surplus  profits  of  the  business. 
Therefore,  the  balance  of  the  Surplus  Account  may  be 
said  to  represent  the  amount  of  profits  which  might  have 
been,  but  were  not,  declared  as  dividends.  A  dividend 


302  Principles  of  Accounting 

might  be  declared  equal  to  the  full  amount  of  the  Surplus 
balance,  but  conservative  management  looks  unfavorably 
upon  any  attempt  to  withdraw  all  the  profits  from  a 
business.  The  wise  executive  fully  appreciates  that 
many  contingencies  may  arise,  and  he  likes  to  build  up  a 
substantial  margin  of  surplus  with  which  to  cushion  the 
shock  of  unexpected  disaster  and  loss.  In  some  indus- 
trial concerns  this  conservative  plan  has  been  so  con- 
sistently followed  that  the  surplus  is  often  several  times 
larger  than  the  total  capital  stock.  Stockholders  are 
usually  hungry  for  dividends,  and  when  they  see  a  large 
surplus,  they  feel  that  the  management  has  been  nig- 
gardly in  its  dividend  declarations.  It,  therefore,  has 
become  customary  to  reserve,  appropriate,  or  "earmark" 
certain  portions  of  the  surplus  as  being  unavailable  for 
dividends. 

This  is  usually  accomplished  by  transferring  a  certain 
portion  of  the  surplus  to  a  reserve  account.  Such  re- 
serves are  always  for  contingencies.  Thus,  a  powder 
company  may  carry  a  large  reserve  to  provide  protection 
against  the  consequences  of  explosions.  Big  industrial 
companies  frequently  carry  reserves  to  absorb  the  shock 
of  unexpected  losses  by  fire,  flood,  or  war.  If  the 
unexpected  should  happen  and  a  large  loss  be  suffered,  it 
would  then  be  charged  direct  to  the  reserve  account 
instead  of  to  Surplus  or  Profit  and  Loss.  The  true 
reserve,  therefore,  is  nothing  more  nor  less  than  appro- 
priated surplus,  which  has  been  especially  set  aside  for 
a  specific  purpose. 

PREMIUM  ON  STOCK 

The  laws  of  many  states  forbid  corporations  to  sell 
shares  of  stock  for  less  than  par,  but  there  is  no  restric- 
tion against  selling  it  for  more  than  par.  It  sometimes 


Corporations  303 

happens  that  a  corporation  wishes  to  begin  its  life  with 
a  surplus.  This  being  the  case,  it  will  sell  its  capital 
stock  for  an  amount  pver  par.  For  example,  one  starting 
in  business  might  have  $100,000.00  worth  of  stock  for 
sale.  In  order  to  create  a  surplus  it  might  sell  this  stock 
for  $125,000.00.  Since  the  Capital  Account  must  show 
par  value  of  the  stock  outstanding,  the  $25,000.00 
premium  should  be  credited  to  some  other  account  ulti- 
mately transferable  to  Capital  Surplus.  It  would  be 
considered  bad  practice  to  credit  it  direct  to  the  Surplus 
Account,  since  it  may  not  seem  desirable  to  indicate  this 
premium  as  being  available  for  dividends.  It  should  be 
noted  in  this  connection  that  there  seems  to  be  no  legal 
restriction  against  using  such  premiums  for  dividend 
purposes,  but  it  would  be  poor  business  practice  to  do  so. 

DISCOUNT  ON  STOCK 

The  statutes  of  some  states  allow  corporations  to  sell 
stock  for  less  than  par.  When  this  is  true,  the  difference 
between  the  price  realized  and  the  par  value  should  be 
charged  to  Discount  on  Stock.  Discount  on  Stock  really 
is  equivalent  to  Capital  Deficit,  and  this  title  may  be  used 
where  appropriate. 

UNISSUED  AND  TREASURY  STOCK 

Stock  that  has  never  been  issued  may  not  appear  on 
the  corporation's  books,  but  if  it  has  once  been  issued 
and  has  then  come  back  to  the  corporation  either  by 
purchase  or  by  gift,  it  must  be  treated  as  an  asset  under 
the  caption  of  "  Treasury  Stock. "  Many  people,  who 
should  know  better,  are  accustomed  to  call  unissued  stock 
"treasury  stock,"  but  the  best  authorities  are  unanimous 
in  condemning  such  practice.  Treasury  stock  should 
represent  only  stock  which  has  once  been  issued  for  value 
and  has  come  back  to  the  corporation. 


304 


Principles  of  Accounting 


If  unissued  stock  is  booked  as  a  debit  item,  it  will  act 
as  an  offset  to  the  credit  balance  of  Authorized  Capital 
Stock.  It  is  not  an  asset  and  should  not  be  shown  as  one 
on  the  balance  sheet.  Rather  it  should  appear  as  a  deduc- 
tion from  the  amount  of  authorized  stock,  thus : 

BALANCE  SHEET 


Assets 


,$100,000.00 


$100,000.00 


Authorized 
Capital 
Stock $250,000.00 

Less    Unis- 
sued   150,000.00 


$100,000.00 


$100,000.00 


Under  such  an  arrangement  there  is  no  account  for 
capital  stock  issued,  the  amount  of  outstanding  shares 
being  determined  from  the  two  accounts,  Authorized 
Capital  Stock  and  Unissued  Stock. 

A  single  corporation  might  have  as  many  as  eight  or 
even  more  main  proprietorship  accounts: 


1.  Capital  Stock  Preferred 

2.  Capital  Stock  Common 

3.  Treasury  Stock 

4.  Capital  Surplus  or  Deficit 

5.  Reserves  (appropriations  of  surplus) 

6.  Surplus  or  Deficit  (from  operation) 

7.  Undivided  Profits 

8.  Profit  and  Loss  Allocation 


Corporation 
Proprietary 
Accounts 


The  algebraic  2  sum  of  all  these  items  would  represent 
the  net  worth  of  the  corporation. 

In  this  section  of  accounting,  as  in  nearly  all  others, 

2  The  word  ' '  algebraic ' '  is  used  here  inasmuch  as  an  arithmetical  eum 
would  be  incorrect.  Algebraic  recognizes  minus  as  well  as  plus  quantity; 
as,  in  the  expression  6x  —  5y,  the  arithmetical  sum  of  the  coefficients  is  11 ; 
the  algebraic  sum  of  +  6  and  —  5  is  + 1. 


Corporations  305 

there  is  no  standardized  terminology  for  the  practitioner 
or  the  student.  The  accounts  as  they  are  listed  above 
represent  the  titles  usually  given  to  them. 

OPENING  ENTRIES 

When  a  corporation  is  organized,  it  becomes  necessary 
to  open  the  books  of  account.  It  is  not  necessary  to 
discuss  the  various  entries  in  the  subsidiary  ledgers,  since 
the  use  of  controlling  accounts  has  been  thoroughly 
treated  in  Chapter  II.  From  the  general  ledger  view- 
point only,  opening  entries  divide  themselves  naturally 
into  four  classes. 

1.  Stock  paid  for  in  cash  and  issued  immediately. 

2.  Stock  paid  for  in  assets  other  than  cash  and  issued 
immediately. 

3.  Stock  subscribed  for,  but  unpaid,  which  is  issued 
immediately. 

4.  Stock  subscribed  for  and  unpaid  to  be  issued  when 
paid. 

The  opening  entry  in  the  first  case  may  be  a  simple 
one. 

Cash  $ 

Capital  Stock $ 

The  opening  entry  when  property  instead  of  cash  is 
turned  over  may  be  equally  simple. 

Sundry  Assets   $ 

Capital  Stock $ 

Where  stock  may  be  issued  as  soon  as  it  is  subscribed 
for,  the  opening  entry  may  be : 


Subscribers  (a  controlling  account) 
Capital  Stock 


306  Principles  of  Accounting 

In  the  above  entry  Subscribers  is  a  general  ledger 
controlling  account  over  the  Subscription  Ledger,  which 
contains  the  detail  accounts  with  each  subscriber.  If  the 
corporation  is  a  small  one  and  the  number  of  subscribers 
few,  their  accounts  may  be  carried  in  the  General  Ledger, 
in  which  case  the  entry  might  appear  as  follows : 

Jones    $ 

Smith 

Brown    

Carr    

Johnson    

Herman   

Capital  Stock $ 

It  will  be  noted  that  the  subscribers '  accounts  represent 
an  asset  of  the  corporation,  since  subscriptions  are  legally 
binding  when  accepted  and  constitute  an  enforceable 
claim,  which  the  corporation  holds  against  its  subscribers. 

Often  stock  may  not  be  issued  until  it  is  entirely  paid 
for.  In  this  case  the  opening  entry  may  be : 

Subscribers     $ 

Capital  Stock  Subscribed $ 

The  account  entitled  "  Capital  Stock  Subscribed " 
registers  the  liability  of  the  corporation  to  issue  capital 
stock.  When  a  subscription  is  paid  up  in  full,  Cash 
must  be  debited  and  Subscribers  credited  for  the  amount, 
and  when  the  stock  certificates  are  issued  to  the  sub- 
scriber, Capital  Stock  Subscribed  will  be  debited.  As  an 
illustration  of  this  procedure,  assume  a  corporation 
where  the  total  subscriptions  equal  $10,000.00. 

Subscribers   $10,000.00 

Capital  Stock  Subscribed $10,000.00 

If  one  of  the  stockholders  paid  $800.00  in  full  for  his 


Corporations  307 

subscription  of  8  shares  at  par  of  $100.00,  the  following 
two  entries  would  be  made : 

Cash    $800.00 

Subscribers $800.00 

(Also  credit  the  individual  account  in  the  Subscription  Ledger) 

Capital  Stock  Subscribed $800.00 

Capital  Stock    $800.00 

(Also  credit  individual  stockholder's  account  in  the  Stock  Ledger) 

If  one  of  the  other  subscribers,  John  Jones  by  name, 
should  pay  his  conditional  subscription  to  30  shares  in 
the  following  assets : 

Buildings   $1,000.00 

Land 500.00 

Merchandise    1,500.00 

the  following  entries  might  be  made : 

Sundry  Assets   $3,000.00 

John  Jones — Vendor $3,000.00 

John  Jones — Vendor $3,000.00 

Subscribers    $3,000.00 

(Also  credit  John  Jones'  account  in  the  Subscription  Ledger) 

Capital  Stock  Subscribed $3,000.00 

Capital  Stock  $3,000.00 

(Also  credit  John  Jones'  account  in  the  Stock  Ledger) 

Buildings    $1,000.00 

Land 500.00 

Merchandise    1,500.00 

Sundry  Assets    $3,000.00 

The  alternative  entries  for  the  above  would  be : 

Buildings  $1,000.00 

Land 500.00 

Merchandise 1,500.00 

John  Jones — Vendor    $3,000.00 


308  Principles  of  Accounting 

John  Jones — Vendor $3,000.00 

Subscribers   $3,000.00 

(Also  credit  John  Jones'  account  in  the  Subscription  Ledger) 

Capital  Stock  Subscribed $3,00.0.00 

Capital  Stock $3,000.00 

(Also  credit  John  Jones'  account  in  the  Stock  Ledger) 

The  reason  for  making  the  entry,  debiting  Sundry 
Assets  for  the  total  of  all  assets  turned  over  by  John 
Jones,  is  one  of  convenience,  since  it  may  be  necessary 
to  appraise  the  exact  value  of  certain  of  the  assets  before 
actually  setting  them  up  on  the  books.  By  making  the 
total  entry  to  the  Sundry  Assets  Account  an  opportunity 
is  given  for  making  any  needed  adjustments  in  the  values 
of  the  various  items  before  finally  booking  them. 

To  carry  the  illustration  still  further,  let  us  assume  that 
a  third  subscriber,  George  Holmes,  turned  over  the  total 
assets  of  his  small  business  in  payment  for  his  subscrip- 
tion to  50  shares  of  stock.  The  various  items  which  he 
claims  to  be  worth  $5,000.00  are : 

Merchandise    $2,500.00 

Fixtures 500.00 

Goodwill 2,000.00 

The  entries  would  be  as  follows : 

Sundry  Assets   $5,000.00 

George  Holmes — Vendor   $5,000.09 

George  Holmes — Vendor   $5,000.00 

Subscribers  $5,000.00 

(Also  credit  George  Holmes'  account  in  the  Subscription  Ledger) 

Capital  Stock  Subscribed $5,000.00 

Capital  Stock  $5,000.00 

(Also  credit  George  Holmes'  account  in  the  Stock  Ledger) 

Merchandise   $2,500.00 

Fixtures  500.00 

Goodwill    2,000.00 

Sundry  Assets  $5;000.00 


Corporations  309 

The  balance  of  the  subscribers '  accounts  represents  the 
total  amount  owing  to  the  corporation  by  the  subscribers 
for  its  capital  stock  and  is,  of  course,  an  asset  since  it 
represents  a  claim  which  is  legal  and  enforceable.  If 
subscriptions  are  not  paid  when  due,  the  subscriber  may 
be  sued  for  the  amount.  If  he  is  unable  to  pay  because 
of  insolvency,  the  entries  may  be  reversed  by  debiting 
Capital  Stock  Subscribed  and  crediting  Subscribers  for 
the  amount  involved. 

Sometimes,  depending  upon  statutory  provisions,  the 
contract  of  subscription  contains  a  clause  that  any 
amounts  paid  on  the  subscription  will  be  forfeited,  under 
certain  conditions,  to  the  corporation  if  the  subscriber 
fails  to  fulfill  his  contract.  When  the  amount  so  realized 
is  a  clear  gain,  it  may  be  credited  to  the  Capital  Surplus 
Account. 

Sometimes  it  is  specified  that  the  subscriptions  are  to 
be  paid  in  installments  rather  than  by  a  single  cash  pay- 
ment. In  such  a  case  the  opening  entry  may  indicate  the 
various  installments  by  means  of  separate  subscribers' 
accounts,  thus: 

Subscribers,  Installment  No.  1    $ 

No.  2   

"  "          No.  3   

"  "          No.  4   

Capital  Stock  Subscribed $ 


In  national  banks  the  holders  of  stock  are  liable,  not 
only  for  the  amount  they  have  invested,  but  for  an  equal 
amount  over  and  above  their  investments,  and  it  very 
frequently  happens  that  a  Capital  Surplus  is  created 
upon  organization.  The  difference  between  the  par  of 
the  stock  issued  and  the  actual  amount  received  for  the 
stock  is  credited  to  the  Capital  Surplus  Account.  Illus- 
trative entries  are  shown  herewith : 


310  Principles  of  Accounting 

Subscribers   $150,000.00 

Capital  Stock  Subscribed   $100,000.00 

Capital   Surplus  Subscribed 50,000.00 

Cash   150,000.00 

Subscribers    150,000.00 

Capital  Stock  Subscribed 100,000.00 

Capital   Surplus   Subscribed 50,000.00 

Capital  Stock  Issued 100,000.00 

Capital  Surplus  50,000.00 

When  stock  is  issued  at  a  discount,  in  those  states 
where  it  is  allowed,  the  difference  between  the  par  of 
the  outstanding  stock  and  the  amount  actually  received 
must  be  debited  to  an  account  called  "Discount  on 
Stock/' 

Subscribers   $50,000.00 

Discount  on  Stock 25,000.00 

Capital  Stock  Subscribed $75,000.00 

Cash  50,000.00 

Subscribers    50,000.00 

Capital  Stock  Subscribed 75,000.00 

Capital  Stock  Issued 75,000.00 

DONATED  STOCK 

In  those  states  where  the  laws  prohibit  the  issuance 
of  stock  for  less  than  par,  a  device  is  commonly  employed 
which  depends  for  its  effectiveness  upon  the  fact  that 
treasury  stock  may  be  sold  for  any  amount  that  it  will 
bring,  while  the  shares  when  first  issued  must  be  sold 
for  par  or  above.  The  organizers  of  the  corporation 
will  take  all  the  stock  of  the  corporation  in  return  for 
the  assets  which  they  turn  over.  Then  the  organizers 
will  return  to  the  corporation  a  certain  proportion  of 
their  stock  holdings  as  a  gift.  This  returned  stock 
should  be  booked  as  "treasury  stock,"  and  it  is  then 
available  for  sale  for  less  than  par. 

There  is  an  element  of  manipulation  in  this  procedure, 


Corporations  311 

and  yet  it  is  so  commonly  employed  and  so  universally 
understood  that  very  few  are  deceived.  As  a  direct 
evasion  of  the  law  accountants  must  frown  upon  it,  but 
under  certain  circumstances  the  employment  of  such  a 
device  is  pardonable.  Stock  cannot  always  be  marketed 
at  par  value,  even  though  it  may  be  worth  it.  The 
corporation  must  then  make  the  best  bargain  that  it  can. 
The  property  which  the  organizers  turned  over  to  the 
corporation  may  be  worth  the  entire  par  value  of  the 
stock  which  is  given  them  for  it,  but,  unless  cash  can  be 
raised,  the  corporation  will  be  crippled  and  the  organizers 
suffer  thereby.  In  order  to  insure  the  corporation's 
ultimate  success,  the  organizers  will  cheerfully  donate 
a  percentage  of  their  stock  holdings,  by  the  sale  of  which 
the  corporation  may  raise  working  capital. 

For  example,  assume  a  corporation  which  is  capitalized 
at  $100,000.00.  The  organizers  of  the  corporation  turn 
over  their  plants  and  other  assets  in  exchange  for  the 
entire  stock  issued.  The  first  entry,  therefore,  may 
appear  as  follows: 

Plant  &  Other  Assets $100,000.00 

Capital  Stock  $100,000.00 

The  balance  sheet  of  the  corporation  at  this  point  will 
appear  as  follows : 

BALANCE  SHEET 


Plant  &  Other  Assets.. .  .$100,000.00      Capital  Stock $100,000.00 


A  corporation  cannot  operate  without  having  working 
and  trading  assets.  In  order  to  raise  working  capital, 
the  organizers  turn  over  25%  of  their  holdings  to  the 


312 


Principles  of  Accounting 


corporation.     The   following   journal   entry   shows   the 
proper  booking  : 

Treasury  Stock   $25,000.00 

Donated  Surplus  $25,000.00 

The  balance  sheet  at  this  point  would  appear  as  follows : 

BALANCE  SHEET 


Plant  &  Other  Assets $100,000.00 

Treasury  Stock   25,000.00 


$125,000.00 


Donated  Surplus $  25,000.00 

Capital  Stock    100,000.00 


$125,000.00 


The  corporation  may  now  sell  this  treasury  stock  for 
30  cents  on  the  dollar. 

Cash    $  7,500.00 

Donated  Surplus   17,500.00 

Treasury  Stock    $25,000.00 

At  this  time  the  balance  sheet  would  appear  as  follows : 

BALANCE  SHEET 


Cash $     7,500.00 

Plant  &  Other  Assets 100,000.00 


$107,500.00 


Donated  Surplus $     7,500.00 

Capital  Stock 100,000.00 


$107,500.00 


This  balance  of  Donated  Surplus  may  be  left  on  the 
books  indefinitely,  or  be  transferred  to  Capital  Surplus, 
or  be  used  to  offset  the  Plant  and  Sundry  Assets  Account, 
on  the  theory  that  the  asset  must  have  been  overvalued 
if  the  organizers  were  willing  to  give  up  part  of  their 
stock.  This  is  always  open  to  question,  and  proper 
procedure  would  depend  upon  the  individual  circum- 
stances. If  the  sundry  assets  which  the  organizers 
turned  over  to  the  corporation  were  clearly  overvalued, 


Corporations  313 

then  the  balance  remaining  to  the  credit  of  Donated 
Surplus  should  be  transferred  to  the  credit  of  the  Plant 
and  Sundry  Assets  Account,  thus  reducing  its  value  to 
$92,500.00. 

CORPORATION  PROBLEM 

(Adapted  from  the  Washington  (State)  C.  P.  A. 
Examination,  September,  1907) 

Ames  is  the  owner  of  a  business  with  property  valued 
as  follows: 

Land  &  Building $100,000.00 

Machinery  &  Tools  79,000.00 

Merchandise  Inventory 93,500.00 


Total    $272,500.00 

Ames,  Brown,  Cass,  Daniells,  and  Evers  organized  the 
Ames  Company  (a  corporation)  with  an  authorized  capi- 
tal of  $350,000.00  divided  into  3,500  shares  of  $100.00  each 
under  the  following  conditions: 

Ames  receives  2,725  fully  paid  shares  for  his  property 
as  shown  above. 

Brown  subscribes  for  100  shares. 
Gass  subscribes  for  100  shares. 
Daniells  subscribes  for  100  shares. 
Evers  subscribes  for  125  shares. 

One  hundred  shares  are  placed  in  the  treasury  for 
future  disposition,  and  50  shares  of  fully  paid  stock  are 
given  to  each  incorporator  for  the  cash  payment  of  10% 
of  par  value,  in  consideration  of  services  in  the  organiza- 
tion of  the  company.  Each  incorporator  then  donates 
30  shares  to  the  company  for  sale  to  provide  working 
capital.  Draft  the  necessary  opening  entries  for  the 


314 


Principles  of  Accounting 


Ames  Company,  giving  effect  to  the  above  transactions, 
and  prepare  a  trial  balance. 


JOURNAL 


L.  F.          Debit 
.(a)  $340,000.00 
.(a) 


Credit 


$340,000.00 


Subscription  

Capital  Stock  Subscribed 

For  the  following  subscriptions: 
Ames         2,775  shares 
Brown          150       ' « 
Cass  150      " 

Daniells       150      " 
Evers  175      " 


Total         3,400 

Plant  and  Sundry  Assets (b)     272,500.00 

Ames — Vendor  (b)  272,500.00 

Ames— Vendor    (c)     272,500.00 

Subscription   (c)  272,500.00 

Capital  Stock  Subscribed  (d)     272,500.00 

Capital  Stock  Issued (d)  272,500.00 

Cash    (e)         2,500.00 

Organization  Expense (e)       22,500.00 

Subscription    (e)  25,000.00 

Fifty  shares  given  each  incorporator  for 
$500.00  in  cash  in  consideration  of  services 
in  organization 

Capital  Stock  Subscribed (f)       25,000.00 

Capital  Stock  Issued (f )  25,000.00 

Treasury   Stock  Donated (g)       15,000.00 

Donated   Surplus    (g)  15,000.00 

To  record  donation  of  30  shares  by  each  in- 
corporator to  be  sold  for  working  capital 

Land  &  Buildings (h)     100,000.00 

Machinery  &  Tools  (h)       79,000.00 

Merchandise  Inventory    (h)       93,500.00 

Plant  &  Sundry  Assets (h)  272,500.00 

To  distribute  items  included  in  lump  sum 
total 

SUBSCRIPTION 


(a)   $340,000.00 


$272,500.00   (c) 
25,000.00  (e) 


Corporations 

CAPITAL  STOCK  SUBSCRIBED 


315 


(d)   $272,500.00 
(£)       25,000.00 


$340,000.00   (a) 


PLANT  &  SUNDRY  ASSETS 


(b)   $272,500.00       $272,500.00   (h) 


AMES — VENDOR 


(c)   $272,500.00 


$272,500.00   (b) 


CAPITAL  STOCK  ISSUED 


$272,500.00   (d) 
25,000.00   (f) 


CASH 


(e)   $2,500.00 


ORGANIZATION  EXPENSES 


(e)   $22,500.00 


DONATED  STOCK 


(g)  $15,000.00 


DONATED  SURPLUS 


$15,000.00  (g) 


316 


Principles  of  Accounting 

LAND  &  BUILDINGS 
(h)  $100,000.00 

MACHINERY  &  TOOLS 


(h)  $79,000.00 


MERCHANDISE  INVENTORY 


(h)  $93,500.00 


TRIAL  BALANCE 


Accounts 


Totals 


Balances 


Dr. 


Subscription    $340,000.00 

Capital  Stock  Subscribed  297,500.00 
Capital  Stock  Issued . . . 

Cash    2,500.00 

Organization   Expenses..  22,500.00 

Donated  Stock 15,000.00 

Donated  Surplus  

Land  &  Buildings 100,000.00 

Machinery  &  Tools 79,000.00 

Merchandise  Inventory..  93,500.00 


Cr. 

$297,500.00 
340,000.00 
297,500.00 


15,000.00 


Dr. 

$  42,500.00 


2,500.00 
22,500.00 
15,000.00 

100,000.00 
79,000.00 
93,500.00 


Cr. 

$  42,500.00 
297,500.00 


15,000.00 


Totals  $950,000.00  $950,000.00  $355,000.00  $355,000.00 


COMMENTS  ON  PROBLEM 

The  problem  states  that  * '  100  shares  are  placed  in  the 
treasury  for  future  disposition/'  Since  unissued  stock 
is  not  recognized  on  the  books  of  the  corporation,  the 
phrase  has  no  meaning  so  far  as  this  solution  is  con- 
cerned. Since  the  total  authorized  stock  is  $350,000.00 
and  only  $297,500.00  has  been  issued,  the  unissued  stock 


Corporations  317 

is  $52,500.00.     It  is  improper  to  say  that  it  is  "in  the 
treasury,"  since  it  is  non-existent  until  issued. 

Although  the  problem  states  the  amounts  subscribed 
for,  the  solution  increases  these  amounts  by  50  shares 
per  subscriber.  This  takes  care  of  the  provision  that 
"50  shares  of  fully  paid  stock  are  given  to  each  incor- 
porator  (presumably  in  addition  to  the  amount  they 
agreed  to  take)  for  the  cash  payment  of  10%  of  par 
value  in  consideration  of  services  in  the  organization  of 
the  company."  Since  stock  should  properly  be  shown 
as  "subscribed"  before  being  issued,  this  $25,000.00 
worth  of  stock  is  handled  in  the  solution  as  additional 
subscriptions. 

PEOBLEM  ILLUSTRATING   CHANGE  FROM  PARTNERSHIP  TO 

CORPORATION 

(Adapted  from  the  Washington   (State)   C.  P.  A. 
Examination,  August,  1908) 

Arthur  Adams  and  Benjamin  Bassett  were  partners 
trading  under  the  name  of  Adams,  Bassett  &  Company, 
sharing  all  profits  and  losses  equally.  June  30,  1908, 
the  following  balances  appear  on  their  Ledger: 

Debit  Credit 

Adams — Capital    Account $  70,000.00 

Bassett — Capital    Account 50,000.00 

Land    $  22,000.00 

Buildings   20,000.00 

Machinery  &  Tools   44,000.00 

Furniture  &  Fixtures 2,000.00 

Accounts  Eeceivable 50,000.00 

Cash  7,000.00 

Materials  &  Merchandise    53,000.00 

Accounts  Payable   35,000.00 

Notes  Payable  48,000.00 

Notes  Receivable 5,000.00 


Totals $203,000.00     $203,000.00 


318  Principles  of  Accounting 

On  June  30,  1908,  the  business  is  incorporated  as  the 
Adams-Bassett  Corporation  on  the  following  plan : 

1.  Capital  Stock,  $150,000.00. 

2.  The    Adams-Bassett  Corporation    takes    over    the 
entire  assets  and  liabilities  of  Adams,  Bassett  & 
Company  at  the  book  figures  as  given  above,  except 
(a)  land  of  the  book  value  of  $5,000.00,  which  is 
retained    by    the    partnership;    (b)    the    accounts 
receivable,  which  are  taken  over  at  $48,000.00,  and 
(c)  the  capital  accounts  of  the  partners. 

3.  The  corporation  pays  the  partnership  $30,000.00  for 
the  goodwill  of  the  business. 

4.  Payments  to  the  partnership  are  made  as  follows, 
viz. :  $50,000.00  in  first-mortgage  bonds,   and  the 
balance  in  capital  stock  of  the  corporation. 

5.  After  paying  off  Adams,  Bassett  &  Company  the 
remainder  of  the  capital  stock  is  sold  for  cash  to 
sundry  persons. 

The  land  which  is  retained  by  the  partnership  is  sold 
to  Adams  for  $7,000.00  and  is  charged  to  the  Adams' 
Capital  Account. 

After  the  conclusion  of  the  foregoing  transaction, 
Adams  and  Bassett  dissolve  partnership. 

You  are  required  to  prepare: 

1.  Closing  entries  for  the  partnership  books. 

2.  A  statement  setting  forth  the  partners'  accounts 
down  to  the  final  closing,  beginning  with  the  balances 
shown  by  their  books  on  June  30,  1908. 

3.  Opening  entries  for  the  corporation. 


Corporations 


319 


JOURNAL — ADAMS,  B  AS  SETT  &  COMPANY  (partnership) 

t  L.  F.        Debit  Credit 

30     Adams— Capital  Account    (a)     $  1,000.00 

Bassett— Capital  Account (a)          1,000.00 

Reserve  for  Bad  Debts (a)  $  2,000.00 

Distributing  the  loss  on  accounts  receiv- 
able to  the  partners  equally 

30     Goodwill (b)       30,000.00 

Adams — Capital   Account    (b)  15,000.00 

Bassett — Capital  Account (b)  15,000.00 

To   set  up  the  goodwill  account  on  the 
partnership  books  prior  to  sale 

30     Adams-Bassett   Corporation    (c)     228,000.00 

Goodwill    (c)  30,000.00 

Land    (c)  17,000.00 

Buildings    (c)  20,000.00 

Machinery  &  Tools   (c)  44,000.00 

Furniture   &   Fixtures (c)  2,000.00 

Accounts  Receivable (c)  50,000.00 

Cash    (c)  7,000.00 

Materials   &   Merchandise (c)  53,000.00 

Notes    Receivable    (c)  5,000.00 

Transferring    the    sundry    assets    to    the 

corporation 

30     Accounts    Payable    (d)       35,000.00 

Notes  Payable   (d)       48,000.00 

Reserve  for  Bad  Debts (d)          2,000.00 

Adams-Bassett  Corporation    (d)  85,000.00 

Transferring  the  sundry  liabilities  to  the 
corporation 

30     First  Mortgage  Bonds — Adams-Bassett  Cor- 
poration  (e)        50,000.00 

Stock — Adams-Bassett  Corporation   (e)       93,000.00 

Adams-Bassett  Corporation (e)  143,000.00 

30     Adams— Capital  Account (f )         7,000.00 

Land    (f)  6,000.00 

Adams — Capital  Account (f)  1,000.00 

Bassett — Capital  Account (f)  1,000.00 

To    record   sale   of   land   at  a   profit   of 

$2,000.00   divisible    equally    between   the 

partners 

30     Adams — Capital  Account    (g)       78,000.00 

Bassett — Capital  Account (g)       65,000.00 

First  Mortgage  Bonds — Adams-Bassett 

Corporation    (g)  50,000.00 

Stock — Adams-Bassett  Corporation  .  . .  (g)  93,000.00 

Distributing   the  assets   to   the  partners 
and  closing  the  books 


320 


Principles  of  Accounting 

ADAMS — CAPITAL  ACCOUNT 


1908 

June  30  Loss    on    a/c 

Bee (a)  $  1,000.00 

30  Land      pur- 
chased   ...(f)       7,000.00 
30  Distribution 

of  Assets.,  (g)     78,000.00 


1908 

June  30  Capital V 

30  Goodwill    ...(b) 
30  Profit  —  Sale 
of  Land...(f) 


$86,000.00 


BASSETT — CAPITAL  ACCOUNT 


$70,000.00 
15,000.00 

1,000.00 


$86,000.00 


1908 
June  30  Loss    on    a/c 

1908 
June  30  Capital    V 

$50,000.00 

Eec.      ...    (a) 

$  1,000  00 

30  Goodwill          (b) 

15  000  00 

30  Distribution 
of  Assets..  (g) 

65,000.00 

30  Profit  —  Sale 
of  Land  .  .  (f  ) 

1,000.00 

$66,000.00 

$66,000.00 

JOURNAL — ADAMS-BASSETT  CORPORATION 

L.  P.          Debit 

A  corporation  organized  under  the  laws 
of  the  state  of  with  an  au- 
thorized capital  stock  of  one  hundred 
and  fifty  thousand  dollars  ($150,000.00) 
divided  into  one  thousand  five  hundred 
shares  valued  at  one  hundred  dollars 
($100.00)  each 


Credit 


June  30     Subscribers    (a) 

Capital  Stock  Subscribed (a) 

30     Sundry  Assets (b) 

Sundry  Liabilities  and  Reserve (b) 

Adams-Basset t  &  Co. — Vendors (b) 

30     Adams-Bassett  &  Co. — Vendors (c) 

Bonds — First  Mortgage  . .  % (c) 

Subscribers  (c) 

30     Capital  Stock  Subscribed (d) 

Capital   Stock   Issued (d) 

30     Cash    (e) 

Subscribers    (e) 


$150,000.00 


228,000.00 


143,000.00 


93,000.00 


57,000.00 


$150,000.00 


85,000.00 
143,000.00 


50,000.00 
93,000.00 


93,000.00 


57,000.00 


Corporations 


321 


L.  F.          Debit  Credit 

30     Capital   Stock   Subscribed (f)          57,000.00 

Capital    Stock    Issued (f )  57,000.00 

30     Land    (g)  17,000.00 

Buildings    (g)  20,000.00 

Machinery   &   Tools (g)  44,000.00 

Furniture  &   Fixtures (g)  2,000.00 

Accounts    Receivable    (g)  50,000.00 

Cash    (g)  7,000.00 

Materials  &  Merchandise (g)  53,000.00 

Notes    Receivable    (g)  5,000.00 

Goodwill    (g)  30,000.00 

Sundry    Assets    (g)  228,000.00 

30     Sundry  Liabilities  &  Reserve (h)  85,000.00 

Accounts  Payable (h)  35,000.00 

Notes   Payable    (h)  48,000.00 

Reserve  for  Bad  Debts (h)  2,000.00 

ADAMS-BASSETT  CORPORATION 
TRIAL  BALANCE  OF  TOTALS  AND  BALANCES 

Totals  Balances 

Dr.  Cr.  Dr.  Cr. 

Cash     $      64,000.00  $  64,000.00 

Accounts  Receivable   50,000.00  50,000.00 

Notes  Receivable 5,000.00  5,000.00 

Materials  &  Merchandise 53,000.00  53,000.00 

Land    17,000.00  17,000.00 

Buildings     20,000.00  20,000.00 

Machinery  &  Tools 44,000.00  44,000.00 

Furniture    &    Fixtures 2,000.00  2,000.00 

Goodwill    30,000.00  30,000.00 

Accounts  Payable    35,000.00  35,000.00 

Notes  Payable    48,000.00  48,000.00 

Bonds     50,000.00  50,000.00 

Reserve  for  Bad  Debts 2,000.00  2,000.00 

Capital   Stock   Issued 150,000.00  150,000.00 

Subscribers     150,000.00         150,000.00 

Capital    Stock    Subscribed...       150,000.00        150,000.00 

Sundry   Assets    228,000.00         228,000.00 

Sundry    Liabilities    and   Re- 
serve              85,000.00  85,000.00 

Adams  -  Bassett      &      Co.  — 

Vendors 143,000.00         143,000.00 


$1,041,000.00  $1,041,000.00  $285,000.00  $285,000.00 

CORPORATE  PROFITS  AND  DIVIDENDS 

The  fact  that  the  liability  of  corporate  stockholders 
is  generally  limited  to  the  amount  they  have  invested 


322  Principles  of  Accounting 

in  corporate  shares  is  responsible  for  the  conflicting 
opinions  submitted  by  learned  jurists  and  accountants 
as  to  what  constitutes  a  corporate  profit  usable  for 
dividend  purposes.  One  of  the  fundamental  rules  of 
corporation  law  states  that  profits  must  not  be  paid  out 
of  capital;  i.  e.,  the  stockholder's  investment  must  not 
be  returned  to  him  under  the  guise  of  profits.  Were 
this  allowed,  both  the  stockholders  and  the  creditors  of 
the  corporation  would  be  defrauded.  The  general  rule 
is  that  dividends  must  be  declared  only  out  of  the  surplus 
profits  of  the  business.  The  rule  is  simple  enough,  but 
its  interpretation  is  singularly  difficult. 

In  previous  chapters  we  have  seen  that  all  current 
changes  in  net  wealth  due  to  the  regular  conduct  of  the 
business  must  ultimately  be  reflected  in  the  Profit  and 
Loss  Account.  It  has  also  been  stated  that  certain  losses 
and  gains  not  resulting  from  the  current  normal  business 
operations  are  not  to  be  shown  on  the  Profit  and  Loss 
Account  but  are  to  be  debited  or  credited  direct  to  one 
of  the  main  proprietorship  accounts,  inasmuch  as  they 
represent  the  decreases  and  increases  in  capital  asset 
values,  not  caused  by  the  current  business  activities.  The 
loss  of  a  plant  by  fire,  in  the  absence  of  insurance,  would 
be  chargeable  direct  to  the  Capital  Account  of  a  sole 
proprietorship  or  to  the  Surplus  Account  of  a  corpora- 
tion. A  profit  realized  from  the  sale  of  fixed  assets 
should  never  be  allowed  to  affect  the  net  profit  for  the 
accounting  period  and  should  be  carried  direct  to  the 
Surplus  Account.  When  we  speak  of  net  profits,  there- 
fore, we  are  not  taking  into  consideration  all  changes  in 
net  wealth. 

If  we  admit  that  such  procedure  is  proper,  we  must 
also  make  a  clear  distinction  between  the  items  which 
belong  to  the  Profit  and  Loss  Account  and  those  which 


Corporations  323 

are  purely  capital  losses  and  gains.  At  this  point  we 
find  conflicting  opinions,  and  from  the  maze  of  contra- 
dictory evidence  it  is  practically  impossible  to  draw  any 
definite  conclusion.  Court  decisions,  both  English  and 
American,  exhibit  marked  differences  in  opinion.  That 
the  question  is  a  vital  one  cannot  be  denied,  in  view  of 
the  rule  that  dividends  must  not  be  paid  out  of  capital. 
Suppose  a  corporation  makes  a  net  business  profit  of 
$10,000.00  and  suffers  a  capital  loss  of  $30,000.00  which 
entirely  wipes  out  its  surplus.  May  it  declare  a  $10,- 
000.00  dividend? 

Probably  such  a  dividend  might  be  legally  approved. 
Prom  the  strictest  point  of  view  any  capital  loss  which 
creates  a  deficit  could  well  be  absorbed  by  a  reduction  of 
the  capital  stock,  but  regular  statutory  formalities  must 
be  complied  with  if  capital  stock  is  to  be  reduced.  For 
this  reason  most  corporations  prefer  to  retain  the  item 
of  deficit  on  the  books  for  an  indefinite  period  in  the  hope 
that  future  profits  will  be  large  enough  to  allow  its 
extinguishment.  Here  again  we  must  emphasize  that 
from  a  purely  legal  point  of  view,  there  seems  to  be  no 
necessity  for  extinguishing  a  deficit  out  of  current  busi- 
ness profits.  Ordinary  prudence,  however,  would  indicate 
the  wisdom  of  such  a  course. 

MLNTNG  COMPANIES 

In  the  case  of  a  raining  enterprise  where  the  value  of 
the  capital  asset,  i.  e.,  the  mine,  is  constantly  being 
reduced  through  current  operation,  the  accountant  would 
feel  that  a  sufficient  portion  of  the  profits  should  be 
applied  against  the  book  value  of  the  wasting  asset  to 
extinguish  it  entirely  at  the  end  of  its  life.  This  is 
merely  the  familiar  principle  of  depreciation  in  a  some- 
what different  form.  A  mine  costing  $100,000.00  with 


324  Principles  of  Accounting 

an  estimated  life  of  ten  years  should  ordinarily  be  worth 
only  $50,000.00  at  the  end  of  five  years,  $20,000.00  at  the 
end  of  eight  years,  etc. 

Where  the  number  of  tons  in  the  ground  can  be  deter- 
mined with  fair  accuracy,  it  is  possible  to  base  the  depre- 
ciation of  the  mine  assets  upon  the  number  of  tons  mined. 
Frequently  it  is  impossible  even  to  guess  at  the  tonnage 
of  mineral,  and  this  possibly  accounts  for  the  fact  that 
mining  companies  are  excused  from  the  necessity  of  amor- 
tizing their  wasting  assets.  It  is  assumed  that  the 
investor  in  a  mining  corporation  and  the  creditor  of  that 
corporation  are  both  fully  aware  of  the  precarious  nature 
of  the  venture  and,  therefore,  do  not  need  the  protection 
which  must  be  given  to  the  stockholders  of  industrial 
enterprises.  The  dividends  of  a  mining  corporation 
usually  consist  partly  of  profits  and  partly  of  a  return 
of  capital.  As  long  as  the  stockholders  are  aware  that 
their  invested  capital  is  being  returned  to  them  piece- 
meal, no  harm  is  done ;  but  if  they  labor  under  the  delu- 
sion that  their  large  dividends  are  pure  profit,  their 
capital  remaining  intact,  a  grave  deception  has  been 
practiced  upon  them. 

EEALIZED  PROFITS 

It  is  uniformly  agreed  that  additions  to  surplus  brought 
about  by  "marking  up"  the  value  of  fixed  assets  may  not 
be  used  as  a  basis  for  dividend  declarations.  If  a  fixed 
asset  is  sold  for  an  amount  in  excess  of  its  book  value,  the 
profits  made  may  be  distributed  to  the  stockholders,  but 
until  that  profit  is  actually  realized,  it  must  not  be  dis- 
tributed. 

United  States  court  decisions  are  somewhat  hazy  as  to 
what  constitutes  net  profit,  and  a  literal  reading  of  their 
decisions  would  indicate  that  profits  must  be  realized  in 


Corporations  325 

cash  before  a  dividend  may  be  paid.  Many  of  these  deci- 
sions were  written  by  jurists  who  were  unfamiliar  with 
accounting  principles  and  practice.  This  would  account 
for  the  confusing  and  misleading  language  which  they 
employ.  Surely  it  is  not  reasonable  to  believe  that  the 
courts  would  insist  that  all  accounting  should  be  on  a 
cash  rather  than  on  an  accrual  basis !  One  of  the  funda- 
mental concepts  of  accounting  is  that  a  profit  is  made  at 
the  time  that  the  sale  is  made.  It  makes  absolutely  no  /  £0*\, 
difference  whether  the  merchandise  is  exchanged  for  cash  v 
or  for  some  other  asset  such  as  other  merchandise,  notes,  J 
or  an  account  receivable;  profit  is  realized  at  the  instant 
the  transaction  is  completed — when  a  cause  of  action  has 
arisen  which  can  be  enforced  against  the  debtor.  The 
position  of  the  legal  profession  in  this  matter  of  profits 
is  clearly  untenable,  and  with  the  gradual  increase  of 
accounting  knowledge  among  our  lawyers,  we  may  look 
for  a  radical  revision  of  their  ideas. 

SCRIP  AND  STOCK  DIVIDENDS 

As  long  as  surplus  profits  exist,  a  dividend  may  be  de- 
clared even  though  there  may  not  be  sufficient  cash  to 
pay  that  dividend.  It  is  perfectly  proper  to  pay  divi- 
dends in  assets  other  than  cash.  Many  corporations  have 
declared  scrip  dividends,  and  cases  have  been  known 
where  corporations  declared  dividends  in  merchandise. 
If  cash  is  not  available  in  the  treasury  of  the  corporation, 
it  may  be  borrowed  for  dividend  purposes.  The  alterna- 
tive is  to  declare  a  stock  dividend. 

Scrip  represents  nothing  more  than  the  corporation's 
promise  to  pay.  The  scrip  which  is  issued  is  practically 
equivalent  to  cash  and  may  be  passed  from  holder  to 
holder  just  as  cash  would  be. 

When  a  stock  dividend  is  declared,  the  procedure  may 


326 


Principles  of  Accounting 


be  a  simple  one,  consisting  of  nothing  more  than  a  debit 
to  Surplus  and  a  credit  to  Capital  Stock  Issued.  A  stock 
dividend  must  be  issued  in  the  manner  prescribed  by 
statute. 

Dividends  may  be  declared  out  of  the  Profit  and  Loss 
Allocation  Account,  or  the  Undivided  Profits  Account,  or 
the  Surplus  Account.  While  the  use  of  the  Profit  and 
Loss  Allocation  Account  is  recommended,  it  is  also  con- 
sidered good  practice  to  transfer  the  total  net  profits  for 
the  period  to  Surplus  and  then  to  declare  all  dividends 
from  that  account.  As  an  illustration  of  this  manner  of 
booking  a  dividend  declaration,  the  following  transaction 
may  be  noted : 

BALANCE  SHEET 


Cash  $20,000.00 

Other  Assets 55,000.0*0 


Total  $75,000.00 


Capital  Stock  Issued $50,000.00 

Surplus    25,000.00 


$75,000.00 


JOURNAL  ENTRY 

Surplus    $15,000.00 

Dividends  Payable $15,000.00 

In  accordance  with  resolution  of  the  directors 
meeting  of ,  191 — 

BALANCE  SHEET 


Cash  $20,000.00 

Other  Assets 55,000.00 


$75,000.00 


Dividends  Payable $15,000.00 

Capital  Stock  Issued 50,000.00 

Surplus    10,000.00 


$75,000.00 


JOURNAL  ENTRY 

Dividends  Payable   $15,000.00 

Cash    $15,000.00 

To  pay  dividends  declared  by  Board  of  Directors 
,19- 


Corporations 

BALANCE  SHEET 


327 


Cash $  5,000.00 

Other  Assets    55,000.00 


$60,000.00 


Capital  Stock  Issued $50,000.00 

Surplus    .'. 10,000.00 


$60,000.00 


As  soon  as  a  dividend  is  declared,  it  becomes  a  liability 
to  the  stockholders  and  must  be  so  booked.  It  very  often 
happens  that  stockholders  cannot  be  located,  and  when 
this  is  the  case,  the  dividends  owing  to  them  must  remain 
on  the  books  as  a  liability  until  they  can  be  located.  It  is 
considered  advisable  to  number  each  dividend  declaration 
and  to  open  a  separate  account  for  each  number. 

When  stock  dividends  are  declared,  the  following  book- 
ing would  be  proper : 

BALANCE  SHEET 


Cash     $     2,000.00 

Other  Assets 109,000.00 


$111,000.00 


Dividends  Payable $  10,000.00 

Capital  Stock  Issued 100,000.00 

Surplus   1,000.00 


$111,000.00 


JOURNAL  ENTRY 

Dividends  Payable    $10,000.00 

Capital  Stock  Issued   $10,000.00 

Dividends  paid  in  stock  of  the  corporation  as  au- 
thorized   by    resolution    of    the    directors    dated 

,19- 

BALANCE  SHEET 


Cash $     2,000.00 

Other  Assets 109,000.00 


$111,000.00 


Capital  Stock  Issued $110,000.00 

Surplus    1,000.00 


$111,000.00 


In  case  the  dividend  is  payable  in  scrip  instead  of  in 
cash,  the  booking  is  equally  simple  involving  a  debit  to 


328  Principles  of  Accounting 

Dividends  Payable  and  a  credit  to  Dividend  Scrip  Pay- 
able. When  the  scrip  is  redeemed,  Cash  is  credited  and 
Dividend  Scrip  Payable  is  debited. 

TEST  QUESTIONS 

1.  What  is  a  corporation  ? 

2.  (a)   Name  two  classes  of  capital  stock, 
(b)   Describe. 

3.  (a)  What  is  the  stock  ledger? 

(b)   What  is  its  controlling   account? 

4.  What  are  reserves? 

5.  (a)  What  is  unissued  stock? 
(b)  What  is  treasury  stock? 

6.  (a)  What  are  the  four  classes  of  opening  entries? 
(b)  Outline  sample  entries  for  each  class. 

7.  (a)  What  is  donated  surplus? 
(b)  How  is  it  created? 

8.  What  is  the  rule  regarding  dividends? 

9.  (a)   Give  illustrative  set  of  journal  entries  reflecting  the 
declaration  and  payment  of  scrip  dividends. 

(b)   Of  stock  dividends. 


CHAPTER  XI 

RESERVE  AND  RESERVE  FUNDS 

The  word  "  reserve, "  as  commonly  employed,  has  no 
specific  meaning.  It  may  refer  to  a  valuation  account  or 
to  an  appropriation  of  surplus.  A  valuation  account  in 
a  properly  organized  scheme  of  accounts  should  never 
be  labeled  a  ' l  reserve. ' '  Since  we  find  that  it  is  so  labeled 
by  a  majority  of  business  men  and  accountants,  it  is 
essential  that  we  carefully  distinguish  between  reserve 
accounts  which  are  appropriated  surplus  and  those  which 
are  merely  offsets  to  asset  accounts. 

VALUATION  ACCOUNTS 

One  of  the  first  rules  of  bookkeeping  provides  that  sub- 
traction is  not  an  operation  to  be  employed  in  ledger 
accounts.  The  effect  of  subtraction  is  obtained  by  inser- 
tion on  the  opposite  side.  If  an  asset  account  has  a  debit 
balance  of  $10,000.00,  which  should  be  reduced  to 
$8,000.00,  it  would  be  improper  to  subtract  $2,000.00. 
That  amount  should  be  added  to  the  credit  side  of  the 
account,  thus  bringing  the  balance  of  the  account  to  the 
desired  figure.  Instead  of  crediting  the  asset  account 
itself,  it  is  preferable  to  create  a  valuation  account  to 
receive  the  credit.  Such  a  valuation  account  can  never 
be  considered  alone,  but  must  always  be  considered  in 
connection  with  the  account  which  it  offsets.  The  exist- 
ence of  a  valuation  account  with  a  credit  balance  is  noth- 
ing more  than  an  indication  that  there  exists  an  asset 
account,  which  is  estimated  to  be  overstated.  If  we  have 

329 


330  Principles  of  Accounting 

a  building  worth  $10,000.00,  it  may  appear  on  the  books 
as  being  worth  $15,000.00  if  it  is  offset  by  a  valuation 
account  for  $5,000.00.  To  arrive  at  the  estimated  true 
value  of  such  an  asset,  it  is  necessary  to  deduct  there- 
from the  balance  of  the  offsetting  valuation  account. 

A  valuation  account  is  usually  created  as  a  result  of 
calculations  of  depreciation.  An  asset  when  purchased 
may  be  worth  $10,000.00.  At  the  end  of  a  year,  however, 
it  may  be  worth  only  $9,000.00.  The  $1,000.00  decrease 
may  be  charged  to  Profit  and  Loss  and  credited  direct  to 
the  asset  account,  thus  bringing  its  balance  into  accord 
with  the  fact.  If  it  is  desirable  to  carry  on  the  record 
the  original  cost  of  the  asset,  the  $1,000.00  credit  will  not 
be  made  to  the  asset  account,  but  to  the  Allowance  for 
Depreciation  Account,  in  practice  frequently  designated 
incorrectly  as  "Reserve  for  Depreciation. "  The  value 
of  the  asset  is  then  ascertained  as  follows : 

Book  Statement  of  Asset  Value $10,000.00 

Allowance  for  Depreciation   1,000.00 

Actual  Value  of  Asset 9,000.00 

The  loss  in  the  value  of  the  asset  is,  as  we  shall  see 
later,  an  expense — a  cost  consequent,  we  will  assume, 
upon  operation.  It  takes  place  whether  profits  are  made 
or  not. 

TRUE  RESERVES 

A  true  reserve  is  fundamentally  different  from  a  valua- 
tion account,  since  it  represents  amounts  which  have  been 
set  aside  or  "reserved"  out  of  surplus  for  some  special 
purpose.  We  have  seen  that  surplus  generally  repre- 
sents the  capital  which  is  obtained  by  reserving  profits, 
i.  e.,  withholding  earnings  from  distribution  to  the  stock- 
holders. If  a  corporation  makes  a  profit  in  any  one  year 


Reserve  and  Reserve  Funds  331 

of  $10,000.00,  and  only  declares  dividends  amounting  to 
$5,000.00,  the  balance  would  ordinarily  be  transferred  to, 
or  permitted  to  remain  in,  the  Surplus  Account,  where  it 
would  represent  capital  left  in  the  business  by  the  stock- 
holders. Of  course,  a  surplus  need  not  necessarily  be 
created  in  this  way,  since  it  may  be  brought  into  existence 
through  the  sales  of  capital  stock  at  a  premium  or  by  the 
reduction  in  capital  stock  or  by  the  purchase  of  shares 
in  the  open  market  at  less  than  par  value.  But  since 
these  methods  of  creating  a  surplus  are  not  the  most 
frequently  met,  they  may  be  ignored  for  the  time  being. 
A  surplus  account  is,  in  itself,  a  reserve  account,  although 
it  represents  profits  which  have  been  reserved  for  general 
rather  than  for  specific  purposes.  It  may  be  desirable 
to  segregate  certain  portions  of  this  surplus  under  specific 
titles,  but  this  does  not  change  the  essential  character  of 
the  item. 

A  business  which  had  a  surplus  of  $50,000.00  might 
desire  to  provide  against  explosions  in  their  factory. 
They  might  also  foresee  that  the  progress  of  invention 
and  technical  scientific  improvements  might  render  some 
of  the  machinery  obsolete.  Lastly,  it  might  seem  pru- 
dent to  them  to  provide  in  some  way  against  unusual 
losses  due  to  insolvency  of  their  customers.  They,  there- 
fore, set  aside  or  "  reserve  "  certain  portions  of  their  sur- 
plus to  care  for  these  contingencies. 

JOURNAL  ENTRY 

Surplus  Account    $35,000.00 

Reserve  for  Explosions   $10,000.00 

Eeserve  for  Obsolescence  of  Machinery 20,000.00 

Reserve  for  Possible  Losses  on  Accounts  Receivable  * 5,000.00 

i  Of  course,  the  usual  risk  of  bad  debts  is  chargeable  to  Profit  and  Loss,  the 
credit  being  made  to  the  proper  valuation  account.  Such  a  valuation  account 
would  be  an  offset  to  Accounts  Receivable.  When  a  reserve  is  created,  it  repre- 
sents provision  for  contingent  losses  on  accounts  receivable. 


332  Principles  of  Accounting 

These  three  reserves  are  still  to  be  considered  as  bear- 
ing the  general  label  of  i  i  Surplus. ' '  No  particular  merit 
exists  in  creating  these  accounts,  except  in  so  far  as  they 
indicate  the  plans,  policies,  and  intentions  of  the  manage- 
ment. A  reserve  may  be  transferred  back  into  general 
surplus  just  as  easily  as  it  was  taken  away  and  this  with- 
out scandal  or  serious  criticism.  The  mere  act  of  relabel- 
ing surplus  something  else  cannot  change  its  essential 
characteristics. 

True  reserves  are  generally  created  to  provide  against 
contingencies,  although  they  may  do  no  more  than  fulfill 
the  normal  functions  of  the  Surplus  Account  itself,  i.  e., 
to  provide  a  permanent  increase  in  capital  or  to  equalize 
dividends. 

EFFECT  ON  BALANCE  SHEET  INTERPBETATION 

In  reading  a  balance  sheet,  it  is  clearly  essential  to 
distinguish  between  true  reserves  and  those  so-called  re- 
serves which  are  merely  valuation  accounts.  Since  many 
corporations  do  not  make  this  fundamental  and  vital 
distinction,  it  is  necessary  to  go  behind  the  balance  sheet 
figures  in  order  to  arrive  at  the  actual  facts.  Since  any 
reserve  appearing  on  the  credit  side  of  the  balance  sheet 
may  represent  either  surplus  profits  or  an  offset  to  assets, 
it  is  clear  that  the  condition  of  the  corporation  cannot  be 
definitely  determined  without  investigation. 

As  an  illustration  of  the  difficulties  which  are  brought 
about  by  the  indiscriminate  use  of  the  word  "reserve," 
let  us  consider  the  case  of  a  corporation  owning  ma- 
chinery valued  at  $50,000.00,  the  estimated  depreciation 
on  which  is  $5,000.00  per  year.  This  depreciation  is  an 
expense — is  absolutely  independent  of  profits — and  must 


Reserve  and  Reserve  Funds  333 

be  taken  into  consideration  before  gross  profits  may  be 
determined.     The  usual,  but  erroneous,  entry  would  be 

Depreciation  of  Machinery $5,000.00 

Eeserve  for  Depreciation  of  Machinery $5,000.00 

(The  correct  method  would  be  to  credit  "Allowance 
for  Depreciation  of  Machinery"  instead  of  "Reserve 
for  Depreciation  of  Machinery") 

At  the  end  of  the  year  it  is  found  that  the  business  has 
been  profitable  and  that  the  profits  will  be  larger  than 
usual.  The  directors,  therefore,  decide  that,  in  addition 
to  the  regular  annual  provision  for  depreciation,  they 
will  reserve  a  certain  portion  of  the  profits  to  take  care 
of  possible  depreciation  which  may  be  suffered  in  the 
future  or  deterioration  in  the  nature  of  depreciation  of  a 
contingent  character.  This  is  simply  a  precautionary 
measure,  and,  while  it  would  seem  rather  unnecessary  if 
a  consistent  depreciation  program  had  been  carefully 
planned  and  followed,  it  would  ordinarily  be  regarded  as 
conservative  and  desirable,  in  view  of  the  fact  that  the 
estimated  life  of  any  asset  is  very  little  more  than  an 
expert  guess.  The  creation  of  this  contingent  provision 
against  possible  excess  depreciation  will  be  booked  as 
follows : 

Surplus  (or  Profit  and  Loss  Allocation) $3,000.00 

Eeserve  for  Depreciation  of  Machinery $3,000.00 

On  the  balance  sheet  which  will  be  prepared  at  the  end 
of  the  period  there  will  appear  an  item  of  "Reserve  for 
Depreciation  of  Machinery . .  .  $8,000.00. ' '  Without  inter- 
pretation this  means  little  or  nothing.  On  the  face  of  the 
balance  sheet  the  reader  would  have  to  assume  that  the 
machinery  was  worth  either  $50,000.00  or  $42,000.00. 
There  is  no  possible  way  of  telling  from  the  balance  sheet 
itself  that  the  machinery  is  actually  worth  $55,000.00, 


334 


Principles  of  Accounting 


although  we  know  this  to  be  the  truth,  since  $5,000.00  out 
of  the  $8,000.00  reserve  represents  an  offset  to  the  book 
statement  of  the  asset,  and  the  remaining  $3,000.00  is 
surplus  appropriated  for  contingencies. 

If  the  $5,000.00  depreciation  had  been  credited  to  a 
valuation  account,  such  as  Allowance  for  Depreciation  of 
Machinery,  no  question  could  exist  as  to  the  interpreta- 
tion of  the  balance  sheet.  It  would  be  seen  that  the 
$5,000.00  was  a  logical  reduction  in  the  book  statement  of 
the  asset  and  that  the  $3,000.00  was  a  surplus  item 
reserved,  forming  a  portion  of  the  net  worth. 

In  constructing  a  balance  sheet  it  is  considered  best  to 
show  the  book  statement  of  an  asset  in  an  inside  column 
and  to  deduct  therefrom  the  balance  of  the  valuation 
account,  extending  the  net  amount  into  the  asset  column, 
as  shown  herewith: 

BALANCE  SHEET 


Cash $ 

Accounts  Eeceivable 

Merchandise 

Keal  Estate   

Machinery    . . .  $50,000.00 

Less  —  Allow- 
ance for  De- 
preciation . . .  5,000.00  45,000.00 


Other  Assets 


Accounts  Payable $ 

Capital  Stock 

Appropriated  Surplus: 

Keserve  for  Explosions 

Keserve  for  Depreciation 

of  Machinery   3,000.00 

Surplus    


True  reserves  should  be  shown  as  indicated  in  the 
above  balance  sheet  and  may  be  properly  labeled  as 
' '  Appropriated  Surplus. ' '  The  reader  who  is  acquainted 
with  current  practice  in  balance  sheet  construction  will 
appreciate  that  such  an  arrangement,  while  strictly 


Reserve  and  Reserve  Funds  335 

proper,  is  not  ordinarily  employed,  and  he  should  guard 
himself  against  being  deceived  by  any  other  balance  sheet 
arrangement. 

EESERVE  FUNDS 

Surplus  is  not  represented  by  any  specific  assets  on  the 
opposite  side.  It  is  not  possible  generally  to  pick  out  any 
particular  items  of  resources  and  to  label  them  as  being 
offsets  to  Surplus.  Both  capital  stock  and  surplus  are 
represented  among  the  assets  to  be  sure,  but  they  are  not 
specifically  tied  up  to  particular  assets.  Since  reserves 
are  only  appropriated  surplus,  they  are  represented  by 
assets  in  general  rather  than  by  particular  assets.  This 
does  not  mean  that  particular  assets  may  not  be  set  aside, 
but  that  they  need  not  necessarily  be.  A  good  example 
of  this  is  to  be  found  in  corporations  engaged  in  hazard- 
ous occupations,  such  as  powder  mills.  In  anticipation 
of  explosions,  it  is  customary  for  them  to  create  a  fund 
consisting  of  liquid  assets,  such  as  cash  or  readily  mar- 
ketable securities.  The  creation  of  such  a  fund  is  a 
simple  matter  and  requires  nothing  more  than  an  entry 
as  follows : 

Contingent  Fund  (cash) $ 

Cash  $ 

Such  a  fund  consists  of  assets  which  have  been 
specifically  "  earmarked "  or  put  away  for  a  special  pur- 
pose, and  in  the  absence  of  restrictions,  the  funds  may 
be  used  for  purposes  other  than  the  one  suggested  at  its 
creation. 

Certain  kinds  of  funds  are  generally  put  in  the  hands 
of  trustees  and,  when  this  has  been  done  according  to  a 
restrictive  agreement,  the  fund  cannot  be  expended  for 
other  than  its  original  purpose. 


336  Principles  of  Accounting 

There  is  no  accounting  connection  between  the  creation 
of  a  money  fund  and  the  creation  of  a  reserve,  although  it 
often  happens  that  the  two  are  born  at  the  same  time  and 
as  the  result  of  the  same  policy.  A  fund  may  be  created 
without  a  reserve,  and  a  reserve  may  be  created  without 
a  fund,  or  both  may  be  created  at  the  same  time  for  the 
same  purpose.  Let  us  assume  the  case  of  a  company 
with  a  Reserve  for  Contingencies  amounting  to  $10,000.00. 
If  an  explosion  takes  place,  entailing  a  loss  of  $5,000.00 
in  assets,  the  asset  accounts  will  be  credited  and  the  Re- 
serve Account  debited.  If  the  assets  are  replaced,  the 
asset  accounts  will  be  debited  and  Cash  will  be  credited. 

If,  in  addition  to  the  reserve  account,  the  corporation 
had  accumulated  a  money  fund  amounting  to  $10,000.00, 
the  entries  might  be  as  follows : 

Reserve  for  Contingencies $5,000.00 

Sundry  Assets    $5,000.00 

(Charging  the  loss  by  explosion  of  ,  19 — ,  to 

the  contingent  reserve  created  for  that  purpose) 

Sundry  Assets    $5,000.00 

Contingent  Fund  (cash)    $5,000.00 

(To  set  up  as  assets  the  new  buildings  created  from 
the  special  cash  contingent  fund  for  explosions) 

The  difference  between  the  first  and  the  second  case  is 
that  no  fund  exists  in  the  one  and,  therefore,  general  Cash 
was  credited  for  the  amount  required  to  rebuild.  In  the 
second  instance,  a  cash  fund  was  available  and  the  fund 
account  was  credited,  leaving  the  balance  of  the  general 
Cash  Account  untouched. 

A  fund  may  be  created  all  at  one  time  or  be  built  up 
during  a  series  of  years.  In  either  case  the  entry  is  a 
debit  to  the  Fund  Cash  Account  and  a  credit  to  general 
Cash.  It  may  be  deemed  desirable  to  make  a  yearly  pay- 
ment to  the  fund  equal  to  the  amount  credited  to  the  cor- 


Reserve  and  Reserve  Funds  337 

responding  reserve,  but  this  does  not  alter  the  fact  that 
the  creation  of  a  fund  and  the  creation  of  a  reserve  are 
separate  and  distinct  operations. 

SINKING  FUNDS 

A  great  deal  of  confusion  has  been  found  to  exist 
regarding  sinking  funds  for  the  redemption  of  debt. 
When  bonds  are  issued,  it  is  often  customary  to  provide 
in  the  trust  deed  that  a  sinking  fund  must  be  provided 
for  the  redemption  of  the  bonds  at  their  maturity.  As 
a  rough  example,  we  may  assume  that  bonds  amounting 
to  $50,000.00,  payable  in  ten  years,  have  been  issued  and 
that  a  sinking  fund  is  to  be  formed  to  take  care  of  this 
indebtedness  at  its  maturity.  This  simply  means  that 
$5,000.00  must  be  set  aside  each  year  in  a  special  fund, 
and  the  bookkeeping  entry  may  be : 

Sinking  Fund  (cash) $5,000.00 

Cash   $5,000.00 

This  operation  is  repeated  each  year  until  the  end  of 
the  ten  years,  when  the  amount  in  the  sinking  fund  will  be 
equal  to  the  bonds  outstanding.  When  the  bonds  are 
paid,  the  entry  may  be : 

Bonds  Payable $50,000.00 

Sinking  Fund $50,000.00 

If  the  deed  of  trust  had  specified  that  payments  to  the 
sinking  fund  should  be  made  out  of  profits  or  earnings,  it 
would  have  been  necessary  to  create  a  sinking  fund  re- 
serve in  addition  to  creating  the  sinking  fund  itself.  Each 
year  the  entries  would  be : 

Sinking  Fund  (cash)  $5,000.00 

Cash $5,000.00 

Profit  and  Loss  Allocation 5,000.00 

Reserve  for  Sinking  Fund 5,000.00 


338  Principles  of  Accounting 

At  the  end  of  the  ten  years  the  books  would  indicate 
that  the  sinking  fund  held  $50,000.00  and  the  Reserve  for 
Sinking  Fund  had  been  credited  with  $50,000.00.  When 
the  bonds  are  paid,  the  entry  would  be : 

Bonds  Payable $50,000.00 

Sinking  Fund  (cash) $50,000.00 

This  would  leave  the  Eeserve  for  Sinking  Fund  still 
standing  on  the  books.  What  entry  must  be  made  to  dis- 
pose of  it?  The  usual  procedure  is  to  transfer  it  to  Sur- 
plus. The  payment  of  a  debt  cannot,  by  the  very  nature 
of  accounting  science,  affect  Profit  and  Loss.  When  a 
debt  is  created,  assets  are  received,  and  when  a  debt  is 
paid,  assets  are  parted  with.  Neither  of  these  transac- 
tions serves  to  increase  or  decrease  the  profits.  A  man 
who  borrows  $50.00  today  and  repays  it  tomorrow  has 
lost  nothing.  His  entry  when  he  borrowed  the  money 
was: 

Cash    $50.00 

Accounts  Payable $50.00 

When  he  repays  the  debt,  he  will  reverse  the  entry: 

Accounts  Payable   $50.00 

Cash    $50.00 

When  a  corporation  borrows  $50,000.00  for  ten  years 
the  same  principle  is  involved.  It  is,  therefore,  unneces- 
sary and,  in  fact,  improper  from  the  accounting  stand- 
point to  create  a  sinking  fund  reserve,  since  it  must 
eventually  find  its  way  into  the  Surplus  Account,  and  it 
might  just  as  well  have  been  credited  to  that  account  in 
the  first  place.  The  reason  that  such  a  reserve  is  required 
by  the  bondholders  is  that  it  offers  them  additional  secur- 
ity for  their  indebtedness.  A  reserve  for  sinking  fund 
cannot  be  dissipated  by  dividend  declarations,  but  must 


Reserve  and  Reserve  Funds  339 

be  left  untouched  until  the  debt  is  paid.  After  that  it 
may  be  transferred  to  Surplus  and  then  used  as  a  basis 
for  dividend  declarations.  The  creation  of  such  a  re- 
serve is  really  a  doubt  cast  upon  the  items  which  go  to 
make  up  the  surplus  and  acts  to  lessen  the  Surplus  bal- 
ance, which  is  tempting  the  stockholders  and  directors  to 
declare  dividends  to  the  danger  point. 

It  should  be  realized  that  the  creation  of  a  cash  fund 
does  not  make  a  corresponding  liability  reserve  any  more 
secure,  since  a  reserve  may,  it  seems  generally  at  any 
time,  be  thrown  back  into  Surplus  or  utilized  for  purposes 
other  than  that  for  which  it  was  created. 

Sinking  fund  assets  are,  as  stated,  usually  in  the  hands 
of  sinking  fund  trustees.  Trust  companies  or  banks  fre- 
quently act  as  such  trustees,  and  it  is  their  duty  to  safe- 
guard the  interests  of  the  bondholders.  The  sinking 
fund  installments  are  paid  over  to  them  on  certain 
definite  dates,  and  the  corporation  thereafter  exercises 
no  control  over  the  fund,  although  it  does  carry  the  fund 
as  an  asset.  It  is  customary  for  the  trustees  to  invest 
sinking  funds  in  particularly  conservative  securities,  and 
the  income  from  these  securities  belongs  to  the  sinking 
fund  and  must  be  charged  to  the  Sinking  Fund  (asset) 
Account.  Those  returns  on  sinking  fund  investments 
may  be  treated  as  "other  income "  or  may  be  credited 
direct  to  the  corresponding  Sinking  Fund  Eeserve,  if 
there  is  one.  The  latter  plan  seems  to  be  authorized  by 
the  best  modern  practice. 

SINKING  FUND  INSTALLMENTS 

The  operation  of  compound  interest  serves  to  increase 
the  fund  more  rapidly  than  the  bare  amount  of  the  annual 
installments.  These  annual  installments  must,  therefore, 
be  figured  so  that  at  the  maturity  of  the  bonds  the  sum 


340  Principles  of  Accounting 

of  the  installments,  plus  the  interest  on  sinking  fund 
investments,  will  be  exactly  equal  to  the  required  amount. 
The  calculations  in  connection  with  sinking  fund  accounts 
are  rather  complex  and  ordinarily  require  the  use  of 
logarithmic  tables.  Tables  have  been  prepared,  how- 
ever, which  will  do  away  with  making  these  intricate  cal- 
culations, and  a  section  of  such  a  table  is  shown  herewith. 
It  will  be  noted  that  if  interest  is  disregarded,  it  will 
require  an  annual  installment  of  $100.00  in  order  to 
redeem  an  indebtedness  of  $1,000.00  in  ten  years.  When 
we  take  into  consideration  the  fact  of  interest,  it  is  found 
that  an  annual  installment  of  $79.50,  paid  in  at  the  end 
of  each  year,  will  be  sufficient. 

THE  ANNUAL  INSTALLMENT,  PAYABLE  AT  THE  END  OF  EACH  YEAR,  EEQUIEED 
TO  REDEEM  $1,000.00  IN  FROM  1  TO  20  YEARS  AT  A  5%  BATE  OF  INTEREST 


TEARS  INSTALLMENT 

Without  Compound 

Interest  5%  Interest 

1 $1,000.00  $1,000.00 

2 500.00  487.80 

3 333.33  317.21 

4 250.00  232.01 

5 200.00  180.98 

6 166.66  147.02 

7 142.85  122.82 

8 125.00  104.72 

9 111.11  90.69 

10 100.00  79.50 

11 90.91  70.39 

12 83.33  62.83 

13 76.92  56.45 

14 71.42  51.02 

15 66.66  46.34 

16 62.50  42.27 

17 58.82  38.70 

18 55.55  35.54 

19 52.63  32.75 

20..  50.00  30.24 


Reserve  and  Reserve  Funds  341 

The  formula  by  which  these  figures  are  reached  is  as 
follows : 


This  formula  gives  the  annuity  which  would  amount 
to  $1.00  in  "n"  years,  "i"  represents  the  interest  on 
$1.00  for  one  year.  In  order  to  solve  this  formula  it  is 
necessary  to  use  logarithms,  but  we  can  illustrate  it  if 
we  use  a  short  period  of  time,  such  as  four  years,  and 
multiply  without  the  aid  of  the  logarithmic  tables.  In 
this  formula  "i"  equals  .05  (the  interest  rate)  and  "n" 
equals  4  years.  Therefore, 

i  .05 

equals  


The  value  of  (1.05)4  can  be  determined  by  simple  multi- 
plication as  being  1.2155  +.  By  subtracting  1  from  this 
we  get  the  amount  which  must  be  divided  into  the 
numerator : 

.05 

.2155 

When  the  required  division  is  made,  the  arithmetical 
result  is  .23201.  Since  the  calculation  was  made  for 
$1.00,  we  must  multiply  by  1,000  in  order  to  obtain  the 
proper  figure  for  $1,000.00.  .23201  X  1,000  ==  $232.01, 
or  the  amount  required  to  redeem  $1,000.00  in  four  years 
at  5%.  Where  n  (number  of  years)  is  a  large  figure,  it 
will  be  necessary  to  use  logarithmic  tables  in  order  to 
obtain  the  value  of  (1  +  i)n. 


342  Principles  of  Accounting 

SECKET  BESERVES 

Much  has  appeared  in  the  popular  press  during  recent 
years  about  secret  reserves.  Some  of  our  largest  corpo- 
rations are  accused  of  having  created  such  reserves.  A 
secret  reserve,  as  the  name  implies,  is  a  "non-ledger 
asset ";  that  is,  it  does  not  appear  on  the  books  and  is, 
in  fact,  not  a  reserve  at  all  in  the  sense  in  which  we  have 
been  using  the  word.  A  secret  reserve  simply  means 
that  the  company's  net  worth  is  understated,  and  this 
may  be  done  in  one  or  two  ways. 

1.  Some  of  the  assets  may  be  understated 

or  even  entirely  omitted. 

2.  The  liabilities  may  be  overstated. 

Assets  may  be  understated  by  charging  capital  expendi- 
ture to  Revenue  or  by  making  excessive  depreciation 
charges. 

The  advantage  of  a  secret  reserve  is  that  the  company 
is  thereby  enabled  to  absorb  a  large  unexpected  loss  with- 
out anyone  being  the  wiser  so  far  as  the  book  accounts 
are  concerned.  When  the  loss  is  suffered,  enough  of  the 
secret  assets  are  brought  on  to  the  books  to  offset  entirely 
the  assets  which  were  lost.  It  is  related  that  in  a  recent 
panic  one  of  the  large  banks  in  Chicago  was  enabled  to 
charge  off  more  than  $1,000,000.00  worth  of  doubtful 
accounts  without  any  Affect  being  noted  on  the  net  worth, 
as  shown  by  the  financial  statements. 

As  to  the  legitimacy  of  the  secret  reserve  there  can  be 
but  little  question.  Accounts  serve  no  purpose  unless 
they  tell  the  truth.  An  understatement  of  assets  is  theo- 
retically just  as  wrong  as  an  overstatement  of  assets. 

Practically,  many  business  men  and  accountants  favor 
the  creation  of  a  secret  reserve,  and  there  may  be  some 


Reserve  and  Reserve  Funds  343 

justification  for  it  in  the  case  of  a  bank,  whose  very  exist- 
ence is  dependent  upon  public  confidence  and  which  can- 
not afford  to  admit  large  losses,  particularly  during 
years  of  depression  and  panic.  There  is  but  little  war- 
rant for  the  creation  of  a  secret  reserve  by  the  ordinary 
corporation.  The  fact  that  such  secret  reserves  have 
been  looked  upon  as  evidencing  conservatism  has  been 
responsible  for  some  stock  market  manipulations,  from 
which  the  public  has  suffered.  Obviously,  if  a  company's 
net  worth  is  understated,  the  holders  of  its  stock  will 
part  with  it  for  less  than  if  the  accounts  told  the  truth. 
There  can  be  no  question  but  that  such  understatement  of 
assets  or  overstatement  of  liabilities  has  been  sometimes 
made  for  the  sole  purpose  of  enabling  the  officers  and 
directors  to  purchase  stock  of  the  corporation  for  less 
than  its  real  value. 

Many  railroads  of  this  country  have  been  creating 
secret  reserves  for  years  through  charging  capital 
expenditures  to  Eevenue.  Eailroad  companies  have  con- 
structed many  miles  of  double  track  without  setting  up 
the  increased  value  in  the  Property  Account. 

The  tendency  of  modern  accounting  is  distinctly  against 
misstatements  of  fact,  even  where  such  statement  is  made 
following  out  a  policy  of  "  conservatism. " 

SUMMARY 

In  closing  this  chapter  it  seems  desirable  to  reiterate 
one  or  two  of  the  principal  points  which  have  been 
brought  out.  There  is  considerable  danger  of  confusion 
even  among  accountants  as  to  funds  and  reserves.  There 
is  necessarily  no  connection  between  the  creation  of  asset 
funds  and  the  creation  of  reserves,  and  the  fact  that  they 
are  often  created  at  the  same  time  and  in  the  same 
amounts  is  responsible  for  much  of  the  misconception 


344  Principles  of  Accounting 

which  exists.  Eeserves  may  be  created  without  corre- 
sponding funds,  and  when  this  is  done,  the  reserve  is  rep- 
resented by  the  assets  in  general  and  not  by  specific  assets. 
Even  after  reserves  are  created  and  funds  established, 
a  fund  may  in  some  cases  be  used  for  other  purposes, 
leaving  the  reserve  standing  on  the  books.  Or  the  reserve 
may  be  eliminated  without  any  change  in  the  Fund  (cash) 
Account.  This  absolute  independence  of  the  two  is 
purely  an  accounting  independence,  and  where  a  corpora- 
tion pledges  itself  in  a  trust  deed  to  certain  fund  and 
reserve  procedure,  it  must  abide  by  the  terms  of  its 
agreement. 

The  distinction  between  valuation  accounts  and  reserve 
accounts  is  of  exceptional  importance.  A  true  reserve  is 
nothing  more  than  surplus  which  has  been  appropriated 
or  "  earmarked  "  for  a  specific  purpose.  A  reserve  need 
not  necessarily  be  created  from  a  surplus  account,  but 
may  come  from  the  same  accounts  that  feed  the  surplus, 
i.  e.,  from  the  Profit  and  Loss  Account  or  from  the  Profit 
and  Loss  Allocation  Account.  It  is  essentially  a  portion 
of  Surplus,  even  though  it  comes  from  Undivided  Profits, 
since  the  balance  of  Undivided  Profits,  which  is  trans- 
ferable to  Surplus,  is  diminished  by  the  amount  of  the 
credit  to  Reserve. 


TEST  QUESTIONS 

1.  (a)  What  is  a  reserve? 

(b)  What  is  a  valuation  account? 

(c)  What  is  the  proper  balance  sheet  treatment  of  each? 

2.  What  are  reserve  funds? 

3.  What  accounting  relation  exists  between  reserve   funds 
and  reserves? 

4.  (a)  What  is  a  sinking  fund? 


Reserve  and  Reserve  Funds  345 

(b)  What  is  meant  by  "creating  a  sinking  fund  out  of 
profits"? 

5.  (a)   How  are  sinking  fund  installments  calculated? 

(b)  What  entry  should  be  made  for  interest  received  on 
a  sinking  fund?  For  interest  accrued  on  a  sinking  fund  at  the 
end  of  an  accounting  period? 

6.  (a)   How  may  secret  reserves  be  created? 
(b)  Are  secret  reserves  ever  justifiable? 


CHAPTER  XII 

DEPRECIATION 

One  of  the  unalterable  laws  of  nature  is  that  of  the 
disintegration — generally  the  "wearing-out" — of  all 
material  things.  It  is  universally  observed  that  any  kind 
of  property  loses  its  usefulness  as  time  passes.  This  loss 
is  principally  caused  by  the  wear  due  to  its  employment, 
although  other  factors  may  contribute  to  the  same  end. 

When  we  speak  of  "  depreciation, "  we  are  referring  to 
this  well-known  phenomenon,  but  the  word  applies  more 
particularly  to  the  wearing-out  of  perishable  material 
property  owned  by  a  business  other  than  that  which  is 
intended  for  resale.  Illustrations  of  such  perishable 
material  property  are  buildings,  machinery,  fixtures,  roll- 
ing stock,  and  tools.  While  some  merchandise  unques- 
tionably lessens  in  value,  due  to  the  passage  of  time,  it 
will  be  understood  that  the  term  "  depreciation "  does 
not  ordinarily  refer  to  anything  except  assets  of  the 
above  nature  used  by  a  business. 

As  Professor  Hatfield  has  so  well  stated,  "All 
machinery  is  on  an  irresistible  march  to  the  scrap  heap 
and  its  progress,  while  it  may  be  delayed,  cannot  be  pre- 
vented by  repairs."  This  gradual  diminution  in  value 
and  utility  of  fixed  assets  must  be  recognized  in  the  books 
of  account.  Surely  if  a  machine  is  worth  less  each  year, 
the  accounts  representing  that  machine  must  reflect  its 
diminishing  value  rather  than  its  original  purchase 
price. 

346 


Depreciation  347 

DEPRECIATION  A  COST 

This  loss  in  value  is  a  cost  of  doing  business,  just  as 
much  as  labor,  fuel,  oil,  or  any  other  cost  which  is 
incurred  in  order  that  the  business  may  operate!)  If  a 
two  years'  supply  of  coal  should  be  purchased,  iffls  clear 
that  the  proper  entry  at  the  time  of  purchase  would  be  a 
debit  to  Coal  (an  asset  account)  and  a  credit  to  Cash  or 
Accounts  Payable.  At  the  end  of  the  first  year  the  Coal 
Account  would  be  credited  with  the  amount  of  coal  used 
during  that  year,  a  corresponding  debit  going  to  the  Coal 
Used  Account  (an  expense  account).  Thus,  the  Coal 
Account  would  be  reduced  to  the  amount  which  repre- 
sented the  inventory  value  of  the  coal  remaining  on 
hand.  If,  during  the  second  year,  all  the  remaining  coal 
were  consumed,  the  Coal  Account  would,  by  similar 
entries,  be  entirely  balanced. 

This  procedure,  which  is  universally  used  in  handling 
supplies,  is  exactly  similar  to  the  procedure  employed  in 
booking  depreciation.  Assume  that  instead  of  buying 
coal  the  company  had  bought  a  machine  which  was  of 
such  a  nature  that  it  would  wear  out  in  about  two  years. 
At  the  end  of  the  first  year  the  asset  account  representing 
that  machine  might  be  credited  for  one-half  the  cost  and 
an  offsetting  expense  account  charged.  At  the  end  of 
the  second  year  the  same  entry  would  be  made,  thus 
wiping  the  asset  account  off  the  books  entirely.  The 
point  to  be  noted  is  that  the  machine  is  used  up  or  con- 
sumed  in  exactly  the  same  way,  though  not  necessarily  at 
the  same  speed,  that  the  coal  is  consumed.  The  mere  fact 
that  the  average  life  of  a  machine  is  considerably  greater 
than  that  of  the  average  purchase  of  supplies  does  not 
affect  the  method  of  treatment.  If  a  machine  could  be 
bought  which  would  last  one  hundred  years,  it  would  be 


348  Principles  of  Accounting 

necessary  to  spread  the  cost  of  that  machine  over  the 
years  of  its  usefulness,  i.  e.,  perhaps  charging  one- 
hundredth  of  it  each  year  to  Expense. 

Unless  it  is  recognized  that  the  value  of  a  machine  must 
be  spread  over  the  entire  accounting  periods  which  use 
it,  it  is  clear  that  the  total  cost  of  the  machine  will  appear 
as  an  expense  of  the  last  accounting  period  when  it  finally 
proves  unserviceable,  and  this  is  contrary  to  one  of  the 
most  fundamental  principles  of  accounting.  It  would 
not  be  erroneous  to  conceive  of  all  machinery  and  build- 
ing accounts  as  representing  deferred  charges  to  Opera- 
tion, differing  in  no  way  from  the  prepaid  items  which 
are  ordinarily  so  classified.  It  will  be  easily  recognized 
that  the  number  of  periods  over  which  a  deferred  charge 
is  to  be  distributed  can  be  of  no  importance  in  determin- 
ing the  character  of  that  deferred  item.  A  deferred 
charge  to  Operation  which  will  be  wiped  out  in  two  years 
is  not  fundamentally  different  from  one  distributable  over 
a  fifty-year  period. 

FLUCTUATION  AND  DEPRECIATION 

At  this  point  it  should  be  clearly  noted  that  there  is  a 
fundamental  difference  between  depreciation  and  fluc- 
tuation. A  fixed  asset  may  fluctuate  in  value,  but  such 
fluctuation  would  ordinarily  not  be  recognized  on  the 
books.  This  is  because  fluctuation  in  the  values  of  such 
assets  may  be  attributed  to  causes  outside  of  the  business 
itself.  Depreciation,  on  the  other  hand,  is  a  lessening 
in  the  value  of  property,  inevitably  brought  about  by  the 
wear  and  tear  of  constant  use  and  the  lapse  of  time. 
Depreciation  is  inevitable — fluctuation  is  not.  Deprecia- 
tion operates  only  to  lessen  values.  Fluctuation  may 
either  lessen  or  increase  them.  Fluctuation"  in  the  value 
of  fixed  assets,  either  favorable  or  unfavorable,  should 


Depreciation  349 

generally  not  be  recognized  on  the  books  of  account  nor 
taken  into  consideration  in  arriving  at  yearly  profits. 
Depreciation,  on  the  other  hand,  must  be  booked  before 
profits  can  be  determined. 

APPRECIATION 

The  argument  is  often  heard  that  the  depreciation  of 
plant  may  be  offset  by  the  increase  in  the  value  of  land. 
This  might  prove  true  if  the  land  were  to  be  sold,  but 
since  it  is  a  fixed  asset  and  essential  to  the  conduct  of  the 
business,  it  will  presumptively  not  be  sold  unless  the  busi- 
ness is  sold  with  it.  Any  favorable  fluctuation  in  the 
value  of  the  land  will,  perhaps,  never  be  realized,  while 
depreciation  is  an  actual  loss,  the  consummation  of  which 
is  certain.  When  machines  wear  out  and  must  be 
replaced,  it  would  usually  prove  impracticable  to  sell 
real  estate  in  order  to  produce  the  necessary  funds.  This 
clearly  indicates  that  the  nature  of  fluctuation  is  entirely 
different  from  that  of  depreciation  and  that  the  one  can- 
not be  considered  an  offset  to  the  other. 

It  is  important  that  the  reader  should  realize  that 
depreciation  is  a  cost.  Many  companies  state  their 
profits  without  taking  depreciation  into  consideration, 
and  many  others  book  depreciation  only  during  prosper- 
ous years,  ignoring  it  entirely  during  less  favorable 
periods.  To  state  profits  before  depreciation  has  been 
taken  account  of  is  equivalent  to  stating  profits  before 
wages  have  been  considered.  No  profit  can  possibly 
exist  until  current  depreciation  has  been  provided  for 
out  of  gross  revenue. 

CAUSES  OF  DEPRECIATION 

The  depreciation  of  an  asset  may  be  due  to  one  or  more 
of  the  following  causes : 


350  Principles  of  Accounting 

1.  Wear  and  tear  consequent  upon  use. 

2.  Deterioration  due  to  passage  of  time  and 

exposure  to  the  elements. 

3.  Obsolescence. 

4.  Inadequacy. 

5.  Accident. 

The  total  depreciation  of  a  given  asset  may  be  due  to 
any  one  or  all  of  these  five  items.  Ten  years  ago  a 
machine  was  bought  for  $800.00.  Today  it  must  be  dis- 
posed of  to  the  junk-dealer  because  it  is  no  longer  of  any 
use.  Nearly  $800.00  worth  of  value  has  disappeared,  and 
this  may  be  due  solely  to  the  wear  and  tear  of  constant 
use.  The  machine  may  be  absolutely  worn  out.  On  the 
other  hand,  it  may  be  that  it  has  seen  only  a  moderate 
amount  of  active  service  and  that  its  deterioration  has 
been  due  to  exposure  to  the  elements. 

The  third  possibility  is  that  the  machine  has  proved 
inadequate  for  the  service  demanded  of  it.  It  may  be 
practically  as  efficient  as  the  day  when  it  was  bought,  but 
time  and  conditions  have  resulted  in  greater  demands 
being  made  upon  the  machine  which  it  cannot  meet,  and 
it  therefore  must  be  replaced  by  a  newer  and  a  more 
efficient  type,  in  spite  of  the  fact  that  its  life  may  not  be 
half  spent. 

Another  cause  which  often  induces  manufacturers  to 
eliminate  a  perfectly  good  machine  is  that  of  obsoles- 
cence. The  progress  of  invention  in  this  country  is  very 
rapid.  Improvements  in  every  art  and  science  come 
about  rapidly.  In  order  to  keep  up  with  severe  competi- 
tion the  management  must  continually  replace  good 
machines  with  better  ones — with  newer  inventions. 

The  final  subdivision  for  lessening  value  may  be  acci- 


Depreciation  351 

dent,  but  this  can  be  dismissed  since  it  should  be,  and 
usually  is,  covered  by  insurance. 

In  examining  these  several  causes  of  decreasing  value, 
it  is  clear  they  may  be  divided  into  two  distinct  groups- 
one  consisting  of  those  items  which  can  be  foreseen  and 
planned  for,  the  other  comprising  those  which  are  uncon- 
trollable and  usually  unforeseeable. 

Class  I1   (which  can  be  foreseen  and  planned  for). 

(a)  Wear  and  tear  consequent  upon  use. 

(b)  Deterioration  due  to  the  passage  of  time 

and  exposure  to  the  elements. 
Class  21  (cannot  be  foreseen  or  planned  for). 

(a)  Obsolescence. 

(b)  Inadequacy. 

(c)  Accident  (usually  covered  by  insurance). 

Class  1  represents  certainties,  and  Class  2  represents 
contingencies.  The  causes  in  Class  1  are  inevitable  and 
must  be  provided  for  out  of  gross  revenue.  It  is  an 
expense  of  the  same  nature  as  "labor"  or  "supplies 
used."  The  proper  method  of  booking  depreciation  of 
this  kind  is  to  charge  the  amount  to  an  expense  account, 
either  crediting  the  asset  account  with  the  same  figure, 
or  even  better,  crediting  a  "valuation  account,"  for  rea- 
sons heretofore  given.  Such  an  expense  account  may  be 
called  simply  "Depreciation"  or  "Provision  for  Depre- 
ciation." The  valuation  account  may  be  appropriately 
termed  "Allowance  for  Depreciation." 

When  the  rate  of  depreciation  has  been  determined,  a 
charge  is  made  to  the  Depreciation  (expense)  Account 
and  a  credit  to  Allowance  for  Depreciation  at  the  end  of 
every  accounting  period.  When  the  asset  is  finally  dis- 

i  These  two  classes  have  been  called  ' '  physical ' '  and  ' '  functional, ' '  re- 
spectively by  some  accounting  authorities. 


352  Principles  of  Accounting 

posed  of,  the  asset  account  is  credited  and  the  valuation 
account  is  debited.  The  amount  received  for  the  asset  as 
"junk"  is  also  credited  to  the  asset  account  directly  or 
indirectly  through  the  valuation  account,  and  any  small 
balance  which  remains  standing  on  the  book  as  an  asset 
should  be  disposed  of  by  a  charge  to  Depreciation  for  the 
current  period. 

It  is  clear  that  no  one  can  ever  forecast  exactly  how 
long  an  asset  will  remain  useful  or  exactly  how  much  it 
will  bring  when  sold  for  junk.  Hence,  there  may  be  a 
balance  in  the  asset  account,  which  has  not  been  provided 
for  by  the  depreciation  plan.  As  an  example  of  the 
proper  method  of  treatment  in  such  a  case,  let  us  assume 
that  the  books  of  a  company  show  the  Machinery  Account 
with  a  debit  balance  of  $800.00  and  the  Allowance  for 
Depreciation  Account  with  a  credit  balance  of  $700.00. 
The  machine  is  disposed  of  for  $50.00,  and  a  new  machine 
purchased  for  $1,000.00.  The  following  entries  will  cor- 
rectly book  the  transactions : 

Allowance  for  Depreciation $    700.00 

Depreciation   Account    50.00 

Cash  50.00 

Machinery  Account $    800.00 

Machinery  Account 1,000.00 

Cash   1,000.00 

CONTINGENT  DEPRECIATION 

The  causes  included  in  the  second  class  should  properly 
be  provided  for  by  a  true  reserve,  i.  e.,  surplus  appro- 
priated for  contingencies.  Ordinarily  it  cannot  be  con- 
sidered as  a  cost  of  doing  business,  and  since  it  cannot 
be  foreseen  or  guarded  against  in  any  definite  way,  it 
should  be  classed  with  all  other  contingencies,  such  as 
explosions  and  extraordinary  casualties,  and  provided 
for  by  a  reservation  of  profits. 


Depreciation  353 

Many  accountants  and  engineers  do  not  take  this  view 
of  depreciation,  and  it  is  obvious  that  in  some  cases  it 
would  be  grossly  improper.  In  certain  lines  of  business 
the  obsolescence  of  machinery  may  be  anticipated  almost 
as  certainly  as  depreciation  due  to  wear  and  tear.  Exam- 
ples of  such  industries  are  those  connected  with  the  use 
of  electrical  equipment.  Improvements  and  inventions 
in  electricity  can  be  foretold  with  some  degree  of  accu- 
racy, and  obsolescence  can,  therefore,  be  planned  for  in 
advance;  but  in  the  more  established  lines  of  manufac- 
turing, revolutionary  improvements  cannot  be  foreseen, 
and  if  they  are  to  be  provided  against  at  all,  the  provision 
should  be  in  the  nature  of  a  reservation  of  profits. 

When  a  clear  distinction  is  made  between  these  two 
classes  of  causes,  the  balance  sheet  may  exhibit  two  dis- 
tinct classes  of  provisions  for  the  losses.  The  balance 
of  the  valuation  account  will  appear  on  the  left  side  of 
the  balance  sheet  as  a  deduction  from  the  cost  of  the 
asset,  while  the  reserve  account  will  be  shown  as  an  item 
of  appropriated  surplus  on  the  right. 

REPLACEMENTS 

When  replacements  of  assets  are  made,  the  fixed  asset 
account,  representing  the  asset  which  has  been  elim- 
inated, should  be  entirely  closed  out  and  a  new  asset 
account  opened  for  the  incoming  asset.  Some  authori- 
ties justify  an  adjustment  in  the  old  asset  account,  which 
they  feel  accomplishes  the  same  purpose,  but  frequently 
such  an  adjustment  is  not  clear  to  anyone  except  the  man 
ho  made  it. 

PLANT  LEDGER 

It  is  clear  that  the  rates  of  depreciation  for  different 
assets  will  vary  considerably,  and  yet  it  will  be  impossi- 


354  Principles  of  Accounting 

ble  for  the  ordinary  business  to  carry  an  account  on  its 
General  Ledger  for  each  individual  asset.  The  use  of  a 
subsidiary  ledger  and  a  general  ledger  controlling 
account  will  solve  this  difficulty.  This  subsidiary  ledger, 
which  may  be  entitled  the  ' i  Plant  Ledger, ' '  carries  a  sep- 
arate account  for  each  plant  unit,  whether  it  be  a  building 
or  a  machine.  A  controlling  account  in  the  General 
Ledger,  which  may  be  called  ' '  Machinery  and  Buildings,  * ' 
will  represent  the  total  value  of  the  various  plant  units. 

Each  plant  ledger  account  (Figure  71)  may  be  ruled 
so  as  to  show  the  depreciated  value  of  the  machine  from 
year  to  year,  while  the  general  ledger  controlling  account 
will  be  offset  by  a  valuation  account.  In  this  case  the 
Plant  Ledger  is  represented  by  two  accounts  in  the  Gen- 
eral Ledger,  and  the  total  of  the  balances  of  the  Plant 
Ledger  will  be  equal  to  the  total  of  the  Machinery  and 
Buildings  Account  less  the  balance  of  Allowance  for 
Depreciation  of  Plant  and  Machinery.  In  this  case 
neither  the  Machinery  and  Buildings  Account  nor  its 
valuation  account  is  a  true  controlling  account,  but  the 
two  taken  together  constitute  a  complete  control  over  the 
Plant  Ledger. 

As  a  simple  illustration  of  this  kind  of  control  let  us 
assume  that  a  Machine  Ledger  is  controlled  by  the  two 
general  ledger  accounts — Machinery  and  Allowance  for 
Depreciation  of  Machinery.  The  machine  ledger  trial 
balance  at  a  given  date  might  appear  as  follows : 

MACHINE  LEDGER  TRIAL  BALANCE 

Machine  " A"  $1,000.00 

Machine  ' '  B ' '  1,000.00 

Machine  "C"   1,200.00 

Machine  "D" 1,800.00 

Machine  "E"  900.00 

$5,900.00 


Depreciation 


355 


N 


Q-^' 


11 


i  < 


* 


356  Principles  of  Accounting 

The  general  ledger  trial  balance  shows  the  Machinery 
Account  with  a  debit  balance  of  $7,500.00,  and  the  Allow- 
ance for  Depreciation  of  Machinery  Account  shows  a 
credit  balance  of  $1,600.00. 

Machinery   $7,500.00 

Less — Valuation  Account    1,600.00 

Balance  (agreeing  with  Machine  Ledger) $5,900.00 


Carrying  this  illustration  still  further,  we  depreciate 
Machine  "  A  "  $200.00.  To  do  this  we  must  charge  Depre- 
ciation with  $200.00  and  credit  Allowance  for  Deprecia- 
tion of  Machinery  with  $200.00  and  also  credit  the 
Machine  "A"  Account  in  the  Machine  Ledger  with 
$200.00.  After  this  has  been  done  the  books  will  appear 
as  follows : 

MACHINE  LEDGEK  TRIAL  BALANCE 

Machine  "A" x $    800.00 

Machine  "B"  1,000.00 

Machine  "C"   1,200.00 

Machine  ' '  D  " 1,800.00 

Machine  ' '  E "  .  900.00 


Total    .  $5,700.00 


The  general  ledger  trial  balance  figures  exhibit  the 
following,  which  clearly  indicate  the  nature  of  the  plant 
ledger  control : 

Machinery   $7,500.00 

Less— Valuation   Account 1,800.00 

Balance  (agreeing  with  Machinery  Ledger) $5,700.00 

THE  BATE  OF  DEPEECIATION 

Now  that  the  method  of  handling  depreciation  on  the 
books  is  clearly  in  mind,  it  is  necessary  to  consider 


Depreciation  357 

analytically  those  factors  which  determine  the  rate  of 
depreciation.  In  other  words,  now  that  we  have  ascer- 
tained how  to  charge  off  depreciation,  it  is  also  necessary 
to  consider  how  much  should  be  charged  off. 

With  the  elimination  of  the  causes  in  Class  2,  the 
amount  of  depreciation  to  be  charged  off  must  depend 
upon: 

1.  The  original  value  of  the  asset. 

2.  The  residual  or  scrap  value  of  the  asset. 

3.  The  ordinary  life  of  the  asset. 

To  illustrate  this  point  assume  that  a  machine  is  pur- 
chased for  $10,000.00  and  that  similar  machines  under 
similar  conditions  have  had  an  average  life  of  nine  years 
with  an  average  residual  value  of  $1,000.00.  It  is  fair, 
therefore,  to  estimate  that  this  particular  machine  will 
also  remain  in  active  service  for  nine  years  and  that  at 
the  end  of  that  time  it  may  be  sold  for  approximately 
$1,000.00.  The  amount  to  charge  off  is  the  original  value 
less  the  residual  value  ($10,000.00— $1,000.00),  or 
$9,000.00,  and  this  amount  must  be  spread  over  the  life  of 
the  asset,  i.  e.,  nine  years.  Whether  this  amount  should 
be  charged  off  at  the  rate  of  $1,000.00  per  year  or  on  some 
other  basis  will  be  discussed  a  little  later.  At  present 
the  important  point  is  the  method  of  determining  the  total 
amount  which  must  be  charged  off  and  the  total  number 
of  accounting  periods  over  which  the  charge  is  to  be 
spread. 

The  factors  which  determine  the  rate  are  partially 
known  and  partially  indeterminate.  The  original  value 
or  purchase  cost  of  the  asset  is  known.  Its  residual  or 
scrap  value  may  be  foretold  with  a  fair  degree  of  accu- 
racy. But  the  life  of  the  asset  is  difficult  to  determine, 
inasmuch  as  it  is  dependent  upon  at  least  eight  factors : 


358  Principles  of  Accounting 

1.  Character  of  the  asset. 

2.  Use  of  the  asset. 

3.  Surroundings  of  the  asset. 

4.  Character  of  the  plant  management. 

5.  Climate. 

6.  Line  of  industry. 

7.  Carefulness  of  installation. 

8.  Skill  of  employees. 

These  matters  are  not  for  the  accountant,  but  pertain 
peculiarly  to  the  field  of  the  engineer,  whose  estimate  as 
to  the  life  of  an  asset  must  be  depended  upon.  Having 
been  given  this  figure  and  knowing  the  original  value  and 
the  probable  residual  value,  the  accountant's  duty  is  to 
book  the  depreciation  from  year  to  year  upon  one  of  the 
several  universally  accepted  depreciation  methods. 

DEPRECIATION  METHODS 

The  best-known  method  of  depreciation  is  that  entitled 
the  " straight  line  method."  Its  name  arises  from  the 
fact  that  a  graphical  representation  of  the  depreciated 
value  of  the  asset  from  year  to  year  forms  a  straight  line. 
Under  the  straight  line  method  the  total  amount  to  be 
charged  off  is  distributed  equally  to  each  of  the  account- 
ing periods.  Thus,  an  asset  costing  $800.00  with  a  resid- 
ual value  of  $200.00  and  a  life  of  six  years  would  be 
charged  off  at  the  rate  of  $100.00  per  year.  (See  Figure 
72.)  The  objection  to  this  method  is  that  it  does  not  do 
what  it  is  designed  for,  i.  e.,  spread  the  burden  equitably 
over  the  accounting  periods,  because  just  after  a  machine 
is  purchased,  it  requires  little  or  no  expenditure  for 
repairs  and  maintenance,  while  in  the  latter  years  of  its 
life  it  requires  considerable  in  the  way  of  upkeep.  The 
figure  which  must  be  evenly  spread  over  the  machine's 


Depreciation 


359 


.700 


600 


500 


\ 


. 


300 


aoo 


zno 


too 


up  '  I 

8  £ 


FIG.  72. — Chart  Illustrating  Depreciation  Methods 


360  Principles  of  Accounting 

life  is  clearly  the  sum  of  the  depreciation  charge  plus 
the  items  of  maintenance  and  upkeep,  and  in  the  latter 
years  this  sum  is  much  greater  than  in  the  earlier  years 
if  the  "straight  line  method "  is  used. 

The  idea  underlying  the  straight  line  method  is  clearly 
correct,  since  the  use  of  a  machine  benefits  one  period  no 
more  and  no  less  than  any  other  period  and,  if  possible, 
each  period  should  bear  an  equal  part  of  the  total  expense 
of  that  machine.  With  the  straight  line  method  of  depre- 
ciation, however,  the  burden  on  the  last  few  periods  of 
the  machine's  life  is  greater  than  on  preceding  periods, 
because  of  the  heavy  increase  in  the  repairs  and  main- 
tenance cost. 

REDUCING  BALANCE  METHOD 

To  eliminate  the  objections  which  have  been  made  to 
the  straight  line  method  an  alternative  has  been  pro- 
posed, which  is  entitled  ' '  the  reducing  balance  method. ' ' 
Instead  of  the  depreciation  rate  being  a  given  percentage 
of  cost,  the  percentage  is  taken  on  the  diminishing  bal- 
ance. Clearly  the  percentage  must  be  greater  under  this 
system  than  when  the  straight  line  method  is  used  if  the 
same  amount  is  to  be  written  off  in  the  same  length  of 
time.  The  formula  for  obtaining  the  percentage  which 
must  be  used  in  the  reducing  balance  method  is  some- 
what complicated  and  involves  the  use  of  logarithms,  but 
tables  have  been  prepared  which  furnish  these  percent- 
ages. As  an  illustration  of  the  reducing  balance  method, 
assume  a  machine  costing  $800.00  with  a  residual  value 
of  $200.00  and  a  life  of  six  years.  It  may  be  determined 
either  mathematically  or  by  the  use  of  a  table  that  the 
proper  per  cent  figure  to  use  is  20.5%,  which  is  to  be 
taken  on  the  reducing  balance  and  not  on  the  original 
cost. 


Depreciation  361 

REDUCING  BALANCE  METHOD 

Book  Value  of 
End  of  Year  Depreciation 


1901 $164.00  $636.00 

1902 130.38  505.62 

1903 103.65  401.97 

1904 82.40  319.57 

1905 65.51  254.06 

1906 52.08  201.98 

Note. — This  percentage  does  not  quite  reduce  the  book  value  of  the  asset 
to  $200.00,  but  the  small  discrepancy  may  be  thrown  into  the  depreciation  of 
the  last  period. 

With  the  reducing  balance  method  the  burden  of  depre- 
ciation is  much  heavier  in  the  earlier  years  of  the 
machine's  life  than  in  the  later  years,  the  expectation 
being  that  the  increased  burden  in  repairs  and  main- 
tenance in  the  later  few  years  will  tend  to  make  the 
total  annual  burdens  substantially  equal. 

Since  the  formula  which  is  used  for  determining  the 
required  percentage  is  somewhat  difficult  to  apply,  a 
substitute  method  which  gives  good  results  is  sometimes 
employed.  The  method  of  applying  this  substitute  plan 
will  be  apparent  from  the  following  example:  Assume 
a  machine  costing  $800.00  with  a  residual  value  of  $200.00 
and  an  estimated  life  of  six  years.  A  continual  reducing 
fraction  may  be  determined  which  has  as  its  denominator 
the  sum  of  the  figures  of  the  machine 's  life. 

1  year 

2  years 

3  years 

4  years 

5  years 

6  years 


21  =  denominator  of  the  fraction 


362  Principles  of  Accounting 

At  the  end  of  the  first  year  6/21  of  $600.00  will  be 
charged  off.  At  the  end  of  the  second  year  5/21  will 
be  charged  off  and  so  on  until  the  last  year,  when  only 
1/21  is  to  be  charged  off.  The  figures  which  are  obtained 
by  the  use  of  this  method  are  shown  in  the  following 
table: 


Year  Ending 
1901  

SUBSTITUTE 

Sum  of 
the  Years 
1 

FOR  EEDUCING 

Fraction 
Charged  Off 

6/21 

BALANCE  METHOD 

Yearly  Charge 
to  Depreciation 

$171.43 

Book  Value  of 
the  Asset 

$628.57 

1902 

2 

5/21 

142.86 

485.71 

1903  

3 

4/21 

114.28 

371.43 

1904 

4 

3/21 

85.72 

285.71 

1905  

5 

2/21 

57.14 

228.57 

1906  .    . 

6 

1/21 

28.57 

200.00 

21  21/21  $600.00 

The  percentage  used  is  not  that  of  cost,  but  a  percent- 
age of  the  amount  which  is  to  be  charged  off,  i.  e.,  in  this 
case,  $600.00.  A  glance  at  Figure  72  will  show  the  differ- 
ence between  the  Eeducing  Balance  Method  and  this 
"  substitute  "  method. 

EE  VALUATION 

Another  method  of  depreciation  involves  a  revaluation 
or  appraisal  of  the  assets  at  the  end  of  every  accounting 
period.  This  plan  of  ascertaining  depreciation  is  not  rec- 
ommended, not  only  because  of  its  great  expense,  but 
because  it  does  not  result  in  spreading  the  depreciation 
scientifically  over  the  various  accounting  periods 

WORKING  HOURS 

The  fourth  method  bases  depreciation  upon  the  number 
of  running  hours.  Instead  of  estimating  the  life  of  the 
asset  in  terms  of  years  or  months,  it  is  estimated  in  terms 


Depreciation  363 

of  total  working  hours.  After  a  rate  of  depreciation  per 
working  hour  has  been  obtained,  it  is  multiplied  by  the 
total  number  of  hours  a  machine  has  been  running  during 
any  given  accounting  period,  and  the  resulting  figure 
equals  the  depreciation  for  that  period.  Assume  an  asset 
costing  $800.00  with  a  residual  value  of  $200.00  and  an 
estimated  life  of  16,200  working  hours.  In  order  to 
obtain  the  rate  of  depreciation  per  working  hour,  the 
total  amount  to  be  charged  off  must  be  divided  by  the 
total  number  of  working  hours. 

$600.00 

—  —  $.037037  —  hourly  depreciation  rate. 
16,200 

WORKING  HOURS  METHOD 

„    ,    -  -, ,  Hours  Deprecia-  Book  Value 

Working  tion  of  Asset 

1901 2,400  $  88.89  $711.11 

1902 2,450  90.74  620.37 

1903 2,700  100.00  520.37 

1904 2,950  109.26  411.11 

1905 3,010  111.48  299.63 

1906..  2,200  81.48  218.15 


15,710  $581.85 

The  truly  desirable  feature  of  this  method  is  that  the 
depreciation  charge  coincides  precisely  with  the  use  made 
of  the  machine,  it  being  assumed  that  a  machine  depre- 
ciates in  proportion  to  the  amount  it  is  used.  As  a  gen- 
eral thing,  this  running  hour  method  is  highly  recom- 
mended, but  it  is  open  to  the  same  objection  that  was 
observed  in  the  straight  line  method;  viz.,  no  provision 
is  made  for  the  heavy  repair  and  maintenance  charges 
which  must  surely  be  expected  toward  the  end  of  the 
machine's  life.  If  it  were  possible  to  forecast  the  cost 
of  repairs  and  maintenance  accurately,  this  figure  could 


364  Principles  of  Accounting 

be  added  to  the  amount  to  be  written  off  and  the  sum 
of  the  two  could  be  divided  by  the  number  of  working 
hours,  in  order  to  arrive  at  an  hourly  rate.  Unfor- 
tunately it  is  difficult,  if  not  absolutely  impossible,  to 
make  an  accurate  forecast  as  to  the  amount  which  will 
have  to  be  spent  for  repairs  and  maintenance  of  a 
machine. 

Another  method  which  resembles  the  working  hour 
method  is  that  which  bases  depreciation  upon  the  ma- 
chine 's  output,  i.  e.,  pounds,  yards,  or  gallons  of  product. 
This  is  the  method  which  is  employed  in  amortizing 
wasting  assets,  such  as  coal  and  ore  mines,  a  definite 
charge  being  added  to  each  ton  mined  and  sold.  In 
this  connection  it  should  be  carefully  noted  that  the  charge 
is  made  at  the  time  the  mineral  has  been  sold  and  not 
at  the  time  when  it  is  extracted  from  the  mine.  Whether 
the  product  is  below  ground  or  above  makes  no  difference 
with  regard  to  the  total  value  of  the  assets.  As  soon  as 
this  product  is  disposed  of,  however,  the  total  value  of 
the  assets  diminishes  by  the  value  of  one  ton.  The  rate 
per  unit  output  is  determined  by  means  of  estimating  the 
total  number  of  pounds,  yards,  or  gallons  which,  the 
machine  can  produce  before  entirely  wearing  out  and 
then  dividing  the  amount  to  be  written  off  by  these  total 
output  figures,  in  order  to  arrive  at  the  depreciation 
rate  per  unit  of  product. 

ANNUITY  METHOD 

The  annuity  method  of  depreciation  is  based  upon  the 
theory  that  the  cost  of  production  should  include,  not 
only  the  repairs,  maintenance,  and  depreciation,  but  also 
the  interest  on  the  capital  invested  in  the  asset.  The 
annuity  method  is  artificial  and  has  the  very  grave  fault 
of  charging  off  a  greater  amount  during  the  later  years 


Depreciation  365 

of  the  asset's  life  than  during  the  first  few  years,  whereas 
we  have  seen  that  the  reverse  should  be  true.  The 
formula  for  the  annuity  method  is  complex  and  somewhat 
difficult  to  solve.  The  method  itself  has  not  the  approval 
of  the  best  authorities.  The  assumption  that  interest 
on  capital  should  be  included  in  the  cost  of  production 
is  not  universally  accepted,  and  the  method  may  be  dis- 
missed with  the  statement  that  the  attractiveness  of  its 
application  is  mathematical  rather  than  practical. 

SINKING  FUND  METHOD 

What  has  been  said  regarding  the  annuity  method 
may  also  be  applied  to  an  extent  to  the  sinking  fund 
method,  but  since  the  latter  is  one  which  is  in  considerable 
use,  it  cannot  be  so  easily  dismissed.  The  sinking  fund 
method  of  depreciation  is  so  called  because  of  its  use 
in  connection  with  a  sinking  fund.  Every  Allowance  for 
Depreciation  or  Reserve  for  Depreciation  is  represented 
by  assets  in  general,  but  it  is  often  desirable  to  represent 
them  by  assets  in  particular,  segregated  in  the  form  of  a 
fund.  When  the  depreciated  asset  is  disposed  of,  the 
proceeds  of  the  fund  are  used  to  defray  the  cost  of 
replacement.  In  the  discussion  of  sinking  funds  in 
Chapter  XI  it  has  been  noted  that  the  characteristic  of  a 
fund  is  that  it  grows  in  value,  out  of  proportion  to  the 
annual  installments,  owing  to  the  accrual  of  compound 
interest.  Therefore,  the  annual  installments  to  a  sinking 
fund  for  depreciation  need  not  be  so  large  as  the  annual 
provision  under  the  straight  line  method. 

Consider  the  case  of  an  asset  costing  $800.00  with  a 
residual  value  of  $200.00  and  a  life  of  six  years.  On  the 
straight  line  method,  depreciation  of  $100.00  would  have 
to  be  charged  off  at  the  end  of  each  fiscal  period.  If  a 
sinking  fund  were  to  be  created,  it  would  not  be  necessary 


366  Principles  of  Accounting 

to  pay  yearly  installments  of  $100.00,  since  a  less  amount 
will  suffice  to  create  a  sinking  fund  balance  of  $600.00  at 
the  end  of  the  sixth  year.  Assume  that  interest  at  the 
rate  of  6%  can  be  obtained  on  the  sinking  fund  assets 
and  that  at  the  end  of  six  years  the  sinking  fund  must  be 
$600.00.  It  is  required  to  ascertain  the  yearly  install- 
ments which  must  be  transferred  from  the  general  cash 
to  the  sinking  fund. 

$1.00  invested  for  5  years  at  6%  =  $1.3382 
1.00  invested  for  4  years  at  6%  —  1.2625 
1.00  invested  for  3  years  at  6%  =  1.1910 
1.00  invested  for  2  years  at  6%  =  1.1236 
1.00  invested  for  1  year  at  6%  =  1.0600 

At  the  end  of  the  sixth  year    1.0000  goes  to  sinking  fund,  but  earns 

no  interest. 


$6.9753  =  Total  accumulated  value  of 
$1.00  invested  each  year. 

To   determine  the  yearly  installment  to  the   sinking 
fund  a  simple  proportion  can  be  used. 


$1.00   :  $6.975   :    :  X 

X  —  $600.00  -f-  $6.975  =  $86.02 

SINKING  FUND  METHOD 
Cash  Paid  to 


—J- 

of  Year 

1901  ........    $  86.02  $  86.02  $713.98 

1902  ........      86.02  $5.16  91.18      622.80 

1903  ........      86.02  10.63  96.65      526.15 

1904  ........     86.02  16.43  102.45      423.70 

1905  ........     86.02  22.57  108.59      315.11 

1906  ........     86.02  29.09  115.11      200.00 


$516.12       $83.88       $600.00 


Of  course,  it  is  understood  that  the  interest  on  the 
sinking  fund  is  debited  to  the  fund  and  that  the  corre- 


Depreciation  367 

sponding  credit  may  go  either  to  one  of  the  revenue 
accounts  as  a  miscellaneous  earning  or  to  the  Allowance 
for  Depreciation  Account.  If  the  credit  is  treated  as  an 
additional  earning,  then  the  actual  charge  for  deprecia- 
tion must  be  increased  by  the  amount  of  that  earning, 
in  order  than  the  Allowance  for  Depreciation  Account 
may  be  equal  to  the  cash  fund. 

The  most  serious  criticism  of  the  sinking  fund  method 
is  the  one  which  has  been  previously  made  concerning 
the  straight  line  method  and  the  annuity  method;  i.  e., 
the  depreciation  burden  becomes  heavier  as  the  asset 
approaches  the  end  of  its  useful  life. 

COMPARISON  OF  METHODS 

For  a  comparison  of  the  several  standard  methods 
which  have  been  discussed,  reference  should  be  made  to 
Figure  72,  which  shows  the  book  value  of  the  same  asset 
from  year  to  year,  the  only  variation  being  in  the  depre- 
ciation method  employed.  The  straight  line  method,  it 
should  be  noted,  results  in  a  straight  line  on  the  graph. 
The  reducing  balance  method  and  the  "  substitute " 
method  each  results  in  concave  curves  indicating  heavy 
charges  at  the  beginning  of  the  period,  which  are 
lightened  as  the  asset  ages.  The  curve  representing  the 
sinking  fund  is  convex,  indicating  that  the  charge  becomes 
heavier  as  the  time  goes  on.  The  curve  for  the  annuity 
method  would  correspond  with  the  sinking  fund  curve. 
The  same  figures  are  used  in  constructing  these  curves 
that  have  been  used  in  the  several  tables. 

"  DOLLAR  YEARS  "  METHOD 

In  public  utility  work  especially,  it  is  customary  to 
determine  the  composite  life  of  the  plant  as  a  whole  and 
then  to  make  the  annual  depreciation  charge  a  figure 


368  Principles  of  Accounting 

that  will  entirely  write  off  "cost  less  scrap"  value  of  the 
entire  plant  during  that  period.  A  method  often  used 
is  the  Humphrey's  "dollar  years "  method.  This  plan 
first  classifies  the  property  as  to  cost  value  less  scrap 
and  also  as  to  age.  Then  the  class  of  property  having 
the  longest  life  is  used  as  a  base,  and  the  number  of 
renewals  of  other  classes  of  property  during  that  period 
is  determined.  The  next  computation  figures  the  total 
cost  of  renewals  in  each  class  during  the  period.  These 
costs  multiplied  by  the  years  of  life  for  each  class  result 
in  the  total ' '  dollar  years, ' '  which  must  be  divided  by  the 
total  cost  of  all  renewals  during  the  period  to  obtain 
the  composite  life.  This  method  will  be  clear  from  study 
of  the  following  table. 

Life  C°st  Value  Number  of  Total  Cost  Dollar 

Less  Scrap  Renewals  of  Renewals  Years 

50  $1,000.00  1  $     1,000.00  50,000.00 

25  6,000.00  2  12,000.00  300,000.00 

10  3,000.00  5  15,000.00  150,000.00 

5  5,000.00  10  50,000.00  250,000.00 

15  7,000.00  3V3  23,333.33  350,000.00 

40  2,000.00  1%  2,500.00  100,000.00 


$103,833.33  1,200,000.00 

1,200,000.00 

Composite  life  — =  11.55  years 

$103,833.33 

OTHER  METHODS 

Two  other  depreciation  methods,  if  they  can  be  so 
dignified,  have  often  been  used.  They  are  mentioned 
here  only  for  the  sake  of  completeness  and  with  the  hope 
that  their  unscientific  character  may  be  evident.  Depre- 
ciation charges  are  sometimes  made  equivalent  to  main- 
tenance charges.  At  the  end  of  a  given  fiscal  period 


Depreciation  369 

maintenance  charges  are  determined,  and  arbitrarily  the 
same  figures  are  also  used  for  depreciation. 

Another  plan  is  to  base  depreciation  upon  the  year's 
net  profits.  In  periods  of  prosperity  the  depreciation 
charges  will  be  high  and  in  periods  of  adversity  low  or 
non-existent.  Nothing  need  be  said  about  this  method, 
save  that  profits  must  necessarily  be  determined  after 
depreciation;  therefore  the  amount  of  depreciation  can- 
not possibly  be  dependent  upon  the  availability  of  profits. 

An  irregular  depreciation  program  or  plan  may  bring 
hardship  to  certain  classes  of  stockholders,  i.  e.,  those 
holding  non-cumulative  preferred  shares. 

EEPAIRS  AND  MAINTENANCE 

Eepairs  and  maintenance  are  clearly  charges  against 
current  operations,  entirely  separate  and  distinct  from 
the  depreciation  provisions.  Eepairs  can  never  preserve 
a  machine  or  a  building  in  the  condition  it  was  at  the 
time  of  purchase.  It  can  only  postpone  the  evil  day  of 
abandonment  or  renewal.  It  has  sometimes  been  thought 
that  repairs  and  maintenance  should  be  charged  to  either 
Eeserve  for  Depreciation  or  Allowance  for  Depreciation, 
but  since  the  usual  depreciation  program  does  not  con- 
template such  procedure,  it  is  clear  that  it  would  be 
erroneous. 

EENEWALS 

Eenewals,  when  they  are  more  than  a  few  dollars  in 
amount,  should  be  handled  in  the  manner  specified  in  a 
preceding  section.  (See  page  352.)  The  asset  account 
and  the  valuation  account  should  be  wiped  out,  and  the 
renewal  of  the  asset  should  be  set  up  as  a  new  asset 
account. 

One  exception  must  be  noted  to  the  rule  that  repairs 


370  Principles  of  Accounting 

and  maintenance  must  be  charged  to  current  operation 
in  connection  with  the  purchase  of  an  old  run-down, 
worn-out  plant,  which  must  be  repaired  before  it  is  in 
condition  for  operation.  The  necessary  repairs  and 
maintenance  in  such  cases  obviously  are  in  the  nature 
of  capital  expenditures  and  should  be  charged  to  the 
asset  account. 

CONCLUSION 

In  all  the  foregoing  discussion  it  has  been  assumed 
that  an  asset  is  allowed  to  run  down  until  it  is  entirely 
depreciated,  but  as  a  matter  of  fact,  no  asset  should  ever 
be  allowed  to  depreciate  more  than  30%  or  35%.  In 
other  words,  every  asset  should  be  at  a  65%  or  75% 
condition,  and  it  is  kept  in  this  condition  by  means  of 
repairs  and  renewals.  The  renewals  need  not  consist 
of  entire  renewals  of  the  unit,  but  in  partial  renewals 
of  its  various  elements.  No  single  element  of  a  machine 
or  building  can  ever  be  entirely  worn  out,  since  it  must 
be  replaced  before  it  has  reached  the  stage  of  dissolution. 
When  the  cost  of  repairs  and  renewals  becomes  too  heavy, 
the  machine  should  be  discarded  in  favor  of  a  newer  and 
more  efficient  one. 

In  some  lines  of  business  it  is  not  necessary  to  make 
provisions  for  depreciation,  even  though  the  various 
plant  units  are  continually  depreciating,  inasmuch  as  the 
charge  for  replacement,  where  a  large  number  of  units 
are  in  use,  tends  to  become  fairly  constant  from  year  to 
year.  In  a  railroad,  for  example,  the  number  of  loco- 
motives which  are  scrapped  and  the  number  of  new  ones 
purchased  is  about  the  same  from  year  to  year.  The 
same  thing  is  true  as  to  cars  and  other  equipment.  New 
equipment  that  is  purchased  is  charged  to  operation,  and 
the  old  equipment  is  allowed  to  stay  on  the  books  as  an 


Depreciation  371 

asset,  even  though  it  has  been  destroyed.  It  is  only  in  a 
business  where  the  operations  are  enormous  and  where 
the  depreciable  units  are  fairly  small  in  value  compared 
with  the  total  investment  that  this  policy  may  be  fol- 
lowed. For  many  years  the  railroads  of  this  country 
had  no  consistent  depreciation  policies.  Within  the  last 
few  years,  however,  they  have  been  forced  by  the  Inter- 
state Commerce  Commission  to  provide  for  depreciation 
of  their  equipment. 

Another  type  of  property  regarding  which  no  account 
of  depreciation  charges  is  necessary  is  that  mentioned  by 
F.  E.  Webner,  "  Kilns,  furnaces,  etc.,  which  are  actually 
destroyed  or  consumed  in  whole  or  in  part  by  their 
ordinary  operations,  may  have  to  be  rebuilt  so  often 
that  this  renewal  or  maintenance  cost  is  probably 
absorbed  into  production  costs  and  may  thus  obviate 
entirely  the  necessity  for  depreciation  charges. " 


TEST  QUESTIONS 

1.  (a)  What  is  depreciation? 

(b)  How  should  it  be  booked? 

2.  (a)  What  is  appreciation? 

(b)  When  should  it  be  booked? 

3.  (a)  What  is  fluctuation? 

(b)  Where  and  how  should  it  be  booked? 

4.  (a)  What  are  the  five  causes  of  depreciation? 

(b)  Are  they  alike  in  nature? 

(c)  Into  what  two  general  classes  may  they  be  divided? 

(d)  What  does  each  class  represent? 

5.  What  is  the  proper  accounting  treatment  of  replacements? 

6.  Describe  fully  the  relation  between  the  Plant  Ledger  and 
the  General  Ledger. 

.  7.  Upon  what  does  the  life  of  an  asset  depend? 
8.  Name  and  describe  four  methods  of  depreciation. 


CHAPTER  XIII 

SPECIAL   FORMS  OF  STATEMENTS 

When  there  is  insufficient  property  at  a  fair  valuation 
to  pay  debts,  a  person  is  said  to  be  insolvent.  This  state 
of  insolvency  is  interesting  to  the  accountant  because  of 
several  forms  of  statements  or  exhibits  which  are  used 
in  no  other  connection.  These  statements  are  known  as 

The  Statement  of  Affairs. 

The  Deficiency  of  Account. 

The  Statement  of  Realization  and  Liquidation. 

They  are  not  a  part  of  the  regular  accounting  scheme, 
but,  when  appropriate,  they  are  prepared  by  accountants 
and  involve  a  thorough  knowledge  of  accounting  theory. 
The  official  who  is  placed  in  charge  of  an  insolvent  busi- 
ness is  known  as  a  " receiver "  or  a  "trustee."  His 
appointment  comes  from  the  court  in  a  proper  case  upon 
the  demand  of  creditors. 

THE  STATEMENT  OF  AFPAIKS 

As  soon  as  a  receiver  or  trustee  is  appointed,  he  takes 
possession  of  the  books  of  the  insolvent  and  from  them 
prepares  a  balance  sheet.  The  figures  used  are  the  ones 
shown  on  the  books,  no  attempt  being  made  to  arrive 
at  the  actual  realizable  values  of  the  assets.  This  balance 
sheet  which  the  receiver  prepares  has  very  little  value 
except  as  a  basis  for  a  further  statement,  which  is 
universally  known  as  the  "statement  of  affairs,"  and 
which  has  no  legal  standing,  but  which  is  prepared  as 

372 


Special  Forms  of  Statements  373 

administration  data  for  the  use  of  a  receiver  or  trustee 
or  for  a  creditors'  meeting.  The  creditors  and  the 
receiver  are  both  interested  in  one  significant  figure,  viz., 
the  per  cent  of  his  claim  that  each  unsecured  creditor 
may  reasonably  expect  to  receive.  The  statement  of 
affairs  attempts  to  make  such  a  forecast.  No  definite 
form  of  exhibit  is  required,  but  custom  and  usage  have 
fairly  well  standardized  the  method  of  presentment. 

The  assets  are  usually  shown  on  the  left-hand  side  and 
the  liabilities  on  the  right-hand  side.  It  is  customary  to 
list  the  assets  in  the  order  of  their  probable  realization, 
while  the  liabilities  are  usually  listed  in  the  following 
order : 

1.  Entirely  unsecured  obligations. 

2.  Fully  secured  obligations. 

3.  Partly  secured  obligations. 

4.  Contingent  obligations. 

5.  Preferred  obligations. 

In  further  explanation  of  the  fifth  item  it  should  be 
noted  that  certain  kinds  of  liabilities,  such  as  rent  and 
wages,  are  preferred  by  statute  and  must  be  paid  before 
any  other  obligations. 

An  acceptable  form  of  ruling  for  a  statement  of  affairs 
is  shown  in  Figure  73,  although  it  cannot  be  claimed  that 
this  is  rigidly  standard.  It  is  one  which  was  suggested 
by  Esquerre  in  his  Applied  Theory  of  Accounts. 

In  column  1  are  listed  the  assets  in  the  order  of  their 
probable  realization,  and  in  column  2  are  shown  the  book 
values  of  those  assets.  In  column  4  are  shown  the  real 
(appraised)  values  of  the  assets  except  those  which  are 
pledged  to  creditors  as  securities  for  claims.  In  such 
cases,  only  the  equity  of  the  insolvent  or  the  excess  value 


374 


Principles  of  Accounting 


I- 

CT5 

orq 


H      I 


Special  Forms  of  Statements  375 

of  the  asset  is  shown  (this  figure  being  the  appraised 
value  of  the  asset  minus  the  claim  which  it  secures). 

In  column  5  the  liabilities  are  listed,  preferably  in  the 
order  discussed  above,  but  if  not  in  that  order,  at  least 
segregated  into  the  same  classes.  The  order  of  the  lia- 
bilities is  not  of  vital  importance,  but  they  should  be 
classified  under  the  several  group  headings  suggested. 
In  column  6  the  book  values  of  the  liabilities  are  shown, 
and  in  column  8  appear  the  unsecured  claims  and,  in  the 
case  of  partly  secured  creditors,  the  excess  of  claims 
over  their  security.  The  total  footing  of  this  column 
represents  the  entire  unsecured  indebtedness. 

From  the  total  of  column  4  is  deducted  the  total  of  all 
preferred  claims,  the  result  being  the  total  of  assets,  at 
estimated  realizable  value,  which  are  free  to  meet  the 
unsecured  liabilities  listed  in  column  8. 

Columns  3  and  7  are  used  for  convenience  in  making 
deductions  and  eliminations.  The  method  of  using  these 
columns  is  shown  in  the  following  examples.  Suppose 
that  the  value  of  a  pledged  asset  is  less  than  the  liability 
it  secures.  How  would  eliminations  be  made  on  the 
statement  of  affairs? 

1                      2  3                     4                      5                      6                      7                      8 

Pledged  Partly 

Assets  ...$2,000.00  $2.000.00  Secured 

Partly  Liability  .$5.000.00  $5,000.00 

Secured  Less — 

Liability..  5.000.00  Security 

(contra).. 


Liability  Balance 

(contra)  $3,000.00  (unsecured) 

If,  on  the  other  hand,  the  appraised  value  of  the 
pledged  asset  is  in  excess  of  the  liability  it  secures,  the 
differences  between  the  two  will  represent  an  amount 
available  to  apply  on  the  unsecured  indebtedness.  As- 
sume a  current  asset  with  a  book  value  of  $10,000.00, 
appraised  value  of  $7,000.00,  securing  a  liability  of 


376  Principles  of  Accounting 

$5,000.00,  the  statement  for  such  a  situation  will  be  as 
follows : 

12345678 

Pledged  Fully 

Asset    ...$10,000.00  $7.000.00                                   Secured       $5,000.00     $5,000.00 

Less—  Pledged 

Secured  Asset 

Liability  (contra)...                         7,000.00 

(contra)  5,000.00     $2,000.00  

Unpledged 
Balance 
(contra)...  $2,000.00 

After  all  the  figures  have  been  entered  on  the  statement 
of  affairs  according  to  the  form  indicated,  the  fact  will 
appear  that  the  total  of  column  4,  representing  the  free 
assets  at  appraised  value,  subtracted  from  the  footing 
of  column  8,  representing  the  unsecured  indebtedness, 
equals  the  total  deficiency.  This  figure  is  then  posted  to 
column  4,  thus  bringing  the  statement  to  a  balance.  The 
percentage  which  the  unsecured  creditors  should  expect 
to  receive  on  their  claims  is  obtained  by  dividing  the  total 
of  column  4  by  the  total  of  column  8.  This  percentage 
should  always  be  computed  with  the  expenses  of  the  bank- 
ruptcy proceedings  in  mind. 

It  should  be  noted  that  there  is  nothing  sacred  about 
this  arrangement.  The  liabilities  may  appear  on  the  left- 
hand  side  and  the  assets  on  the  right,  or  the  "report" 
form  may  be  used  instead  of  the  statement  form.  The 
liabilities  may  appear  in  the  convenient  order  mentioned 
or  in  any  other  order,  the  same  being  true  about  the 
assets. 

PROPRIETORSHIP  ITEMS 

It  is  not  customary  to  show  under  liabilities  any  of 
those  items  which  represent  proprietorship.  All  items 
of  investments  and  accrued  profits  are  ordinarily  omitted 
but,  if  desired,  they  may  be  shown,  although  they  will 
appear  only  in  column  6  and  not  in  column  8. 


Special  Forms  of  Statements 


377 


EESEKVES 

In  drawing  up  a  statement  of  affairs  for  a  corporation 
the  question  immediately  arises  as  to  what  disposition 
is  to  be  made  of  reserves.  This  cannot  be  answered 
without  an  inquiry  as  to  the  meaning  which  attaches  to 
"  reserve  "  in  the  particular  case.  If  a  reserve  is  classi- 
fied as  Appropriated  Surplus,  it  would  be  considered  as 
a  capital  item  and  probably  not  shown  on  the  statement 
of  affairs.  If  the  reserve  is,  in  reality,  a  valuation 
account,  it  should  be  deducted  from  the  book  value  of  the 
asset  to  arrive  at  its  depreciated  book  value. 

As  an  illustration  of  some  of  the  points  discussed,  the 
following  illustrative  problem  is  presented: 


PROBLEM  ILLUSTRATING  USE  OF  THE  STATEMENT  OF  AFFAIRS 

(Adapted  from  the  New  York  C.  P.  A. 
Examination,  Jan.,  1907) 

On  June  30,  1914,  Ward  and  Parker,  merchants, 
announce  their  inability  to  meet  their  obligations  and 
to  make  an  assignment  for  the  benefit  of  their  creditors. 
From  an  examination  of  their  books,  supplemented  by 
other  information,  their  condition  appears  as  follows : 


ASSETS 


LIABILITIES 


Cash  on  Hand $  6,875.00 

Notes    Eeceivable 5,312.00 

Accounts  Receivable 3,250.00 

Chattels  17,500.00 

Warehouse    Eeceipts    and 

Other  Securities 35,000.00 

Deficiency 15,313.00 


$83,250.00 


Creditors  Unsecured $31,250.00 

Creditors  Partly  Secured..   29,875.00 
Creditors  Fully  Secured. . .   21,250.00 
Taxes    &    Wages    of    Em- 
ployees   (preferred) 875.00 


$83,250.00 


378  Principles  of  Accounting 

We  find  upon  examination  that  the  Profit  and  Loss 
Account  shows  sundry  losses  of  $16,875.00  and  that  the 
trade  expenses  for  the  current  period  equal  $9,250.00. 
The  amount  to  the  credit  of  Ward's  Capital  Account  is 
$12,500.00,  but  his  drawing  account  shows  a  debit  balance 
of  $11,250.00.  Parker's  Capital  Account  shows  a  credit 
balance  of  $20,062.00,  and  his  drawing  account  has  a 
debit  balance  of  $10,500.00. 

Of  the  accounts  receivable  it  is  estimated  that  $1,250.00 
of  them  are  worthless  and  that  $750.00  of  them  are 
doubtful,  although  they  are  expected  to  produce  $250.00. 
Of  the  chattels,  amounting  to  $17,500.00,  it  is  noted  that 
only  $11,250.00  will  be  realized.  The  warehouse  receipts 
and  other  securities  are  in  the  hands  of  creditors  pledged 
to  secure  payment  of  their  accounts,  viz. : 

In  the  hands  of  partly  secured  creditors $  3,750.00 

In  the  hands  of  fully  secured  creditors 31,250.00 

COMMENTS  ON  THE  PROBLEM 

There  is  no  point  of  particular  difficulty  involved  in 
this  problem.  The  method  of  treating  fully  secured  and 
partly  secured  liabilities  is  illustrated  by  the  solution. 

THE  DEFICIENCY  ACCOUNT 

The  deficiency  account  is  an  exhibit  supplementing 
the  statement  of  affairs.  Its  function  is  to  disclose  how 
the  deficiency  has  been  caused,  and  it  may  be  looked  upon 
to  furnish  a  reason  for  the  result  which  the  statement 
of  affairs  shows.  It  is  customary  to  prepare  this  state- 
ment in  account  form,  but  this  is  not  necessary,  since  the 
report  form  is  more  easily  prepared  and  is  more  intel- 
ligible to  the  lay  reader. 


Special  Forms  of  Statements  379 

STATEMENT  OF  AFFAIRS 

Ward  and  Parker,  June  30,  1914 

Assets 

Book  Value  Estimated  to  Realize 

Cash  on  Hand  ........................  $  6,875.00  $  6,875.00 

Bills  Keceivable  .......................     5,312.00  5,312.00 

Accounts  Eeceivable  —  Good  .............     1,250.00  1,250.00 

11             Doubtful   ........        750.00  250.00 

"  "  Bad   ............     1,250.00 

Chattels   ....................  .........   17,500.00  11,250.00 

Warehouse   Eeceipts  ...................   31,250.00  $31,250.00 

Less—  Fully  Secured  Creditors  ..........  21,250.00       10,000.00 

Warehouse  Eeceipts  in  Hands  of  Partly 

Secured  Creditors  —  see  contra  ......     3,750.00 


Total    ...............  .  .......  $67,937.00  $34,937.00 

Deduct—  Preferred    Claims  .............  ~~  875.00 


Balance    Available    for    Distribution    to 

Unsecured  Creditors,  being  59.5%  of 

their    claims  ..................  ....  $34,062.00 

Deficiency    ...........................  23,313.00 


$57,375.00 

Liabilities 

Book  Value  Estimated  to  Rank 

Creditors    Unsecured  ...................  $31,250.00  $31,250.00 

Creditors  Partly   Secured  ..............   29,875.00  $29,875.00 

Less  —  Security  —  see  contra  .............  3,750.00       26,125.00 


Creditors—  Fully    Secured  ..............   21,250.00       21,250.00 

Security  .............................  31,250.00 


Free  Assets  —  see  contra  ................  10,000.00 

Taxes  and  Wages  —  see  contra  ..........        875.00 


Total  Book  Liabilities  ............  .$83,250.00 


Total  Unsecured  Claims  ............  ~~  $57,375.00 


380 


Principles  of  Accounting 


The  deficiency  account  is  charged  with  various  losses 
and  expenses  and  withdrawals  of  capital  and  is  credited 
with  the  invested  capital  and  any  appreciation  in  the 
value  of  assets,  the  balancing  figure  being  equal  to  the 
deficiency  as  shown  by  the  statement  of  affairs. 

In  order  to  collect  the  desired  figures  for  the  deficiency 
account  easily,  it  is  customary  to  add  an  extra  column 
to  the  statement  of  affairs.  The  statement  of  affairs  for 
Ward  and  Parker  with  the  "  deficiency "  column  added 
is  shown  below. 

STATEMENT  OF  AFFAIRS 
Ward  and  Parker,  June  30,  1914 


Book  Value        Estimated  to  Realize        Deficiency 


Cash  on  hand $  6,875.00 

Bills   .Receivable 5,312.00 

Accounts    Eeceivable — Good..  1,250.00 
Accounts  Eeceivable — 

Doubtful    750.00 

Accounts    Keceivable — Bad . . .  1,250.00 

Chattels    17,500.00 

Warehouse   Eeceipts 31,250.00 

Less — Fully    Secured    Credit- 


i  6,875.00 
5,312.00 
1,250.00 

250.00 
11,250.00 


p  500.00 
1,250.00 
6,250.00 


$31,250.00 


21,250.00       10,000.00 


Warehouse  Eeceipts  in  Hands 
of  Partly  Secured  Cred- 
itors— see  contra 3,750.00 


Total    $67,937.00 

Deduct  Preferred   Claims ' 

Balance  Available  for  Distri- 
bution to  Unsecured 
Creditors,  being  59.5%  of 
their  claims 

Deficiency    


$34,937.00     $8,000.00 
875.00  ~ 


$34,062.00 
23,313.00 


Special  Forms  of  Statements 


381 


Liabilities 

Book  Value  Estimated  to  Rank 

Creditors  Unsecured $31,250.00  $31,250.00 

Creditors  Partly   Secured 29,875.00  $29,875.00 

Less— Security— see    confcra 3,750.00       26,125.00 


Free  Assets — see  contra 

Taxes  and  Wages — see  contra. 


875.00 


Total  Book  Liabilities $83,250.00 

Total  Unsecured  Claims . . 


Creditors— Fully    Secured 21,250.00       21,250.00 

Security    31,250.00 


10,000.00 


$57,375.00 


The  deficiency  account  itself  might  appear  as  follows 


DEFICIENCY  ACCOUNT 
Ward  and  Parker,  June  30.  1914 


Sundry   Losses 

and    Expense 
Profit  and  Loss 

Account $16,875.00 

Trade  Expenses     9,250.00  $26,125.00 


Loss  on  Realiza- 
tion of  Assets 

Accounts  R  e  - 

ceivable  $  1,750.00 

Chattels    .  6,250.00       8,000.00 


By     P  a  r  t  n  e  r's 
Drawings 

Ward's   Draw- 

ings    $11,250.00 

Parker's   Draw- 
ings        10,500.00     21,750.00 


$55,875.00 


Capital 

Ward's  Capital  $12,500.00 
Parker's  C  a  p  - 

ital 20,062.00  $32,562.00 


Deficiency  as  per 
Statement  o  £ 
Affairs  ., 


23,313.00 


$55,875.00 


As  an  alternative  arrangement  the  following  would  be 
acceptable : 


382  Principles  of  Accounting 

DEFICIENCY 

(Keport  form) 

Ward  and  Parker,  June  30,  1914 

Loss  on  Eealization  of  Assets  as  Shown  by  Appraisal 

Accounts  Eeceivable $  1,750.00 

Chattels    6,250.00     $  8,000.00 


Sundry  Losses  and  Expense 

Profit  and  Loss  Account $16,875.00 

Trade  Expenses 9,250.00      26,125.00 


Total  Losses $34,125.00 

Invested  Capital 

Ward's  Capital $12,500.00 

Parker's  Capital 20,062.00     $32,562.00 


Withdrawals 

Ward 's  Drawings $11,250.00 

Parker's    Drawings 10,500.00       21,750.00 


Net   Capital 10,812.00 


Deficiency  as  per  Statement  of  Affairs $23,313.00 


The  statement  of  affairs  and  the  deficiency  account 
are  complements  of  each  other.  Both  are  required  to 
make  a  complete  showing.  In  C.  P.  A.  examinations  it  is 
customary  to  call  for  both  the  statement  of  affairs  and  the 
deficiency  account. 

There  has  been  no  professional  standardization  of  this 
statement,  and  no  particularly  good  reason  exists  for 
debiting  rather  than  crediting  the  account  with  losses. 
The  accounting  profession  is  about  equally  divided  on 
the  method  of  preparing  this  statement.  The  important 
thing  to  note  is  the  relation  which  exists  between  it  and 
the  statement  of  affairs.  They  both  end  with  the  same 


Special  Forms  of  Statements  383 

figure,  although  they  arrive  at  it  by  different  paths. 
The  one  acts  as  a  check  and  a  proof  on  the  other. 

STATEMENT  OF  REALIZATION  AND  LIQUIDATION 

The  statement  of  realization  and  liquidation  is  a  logical 
"follow-up"  to  the  two  statements  described.  The 
statement  of  affairs  is  in  the  nature  of  a  prophecy — the 
receiver's  estimate  of  what  his  administration  may  do. 
The  test  of  the  receiver's  accuracy  as  a  prophet  is  the 
record  of  his  actual  accomplishments,  and  this  is  fur- 
nished in  summary  form  by  the  statement  of  realization 
and  liquidation — a  statement  usually  prepared  in  account 
form,  furnishing  a  tabloid  history  of  the  receiver's 
accomplishments.  This  statement  is  often  spoken  of  as 
the  "Realization  and  Liquidation  Account"  and  usually 
appears  in  " account"  form,  but  it  is  not  an  account  under 
a  strict  definition  of  the  word.  It  seldom,  if  ever,  appears 
as  a  general  ledger  account  and,  as  a  matter  of  fact,  it 
may  not  be  looked  upon  even  as  a  practical  statement, 
inasmuch  as  it  consists  of  a  mixture  of  unlike  things,  and 
results  in  a  total  which  the  ordinary  reader  finds  difficult 
of  analysis. 

Various  boards  of  C.  P.  A.  examiners  have  found  the 
preparation  of  this  statement  a  splendid  test  of  the 
student's  analytical  and  synthetical  powers.  For  that 
reason  practically  every  C.  P.  A.  examination  paper 
contains  at  least  one  question  bearing  on  the  construction 
of  this  exhibit. 

When  the  assets  and  liabilities  of  the  business  are 
turned  over  to  the  receiver  or  trustee,  it  is  his  duty — 
acting  under  court  orders — to  realize  on  the  assets,  i.  e., 
turn  them  into  cash  and  provide  funds  to  liquidate  the 
liabilities.  It  is  almost  inevitable  that  some  loss  will  be 
suffered  in  a  quick  sale  of  assets,  particularly  those  of  a 


384  Principles  of  Accounting 

fixed  nature,  and  it  is  possible  that  some  gain  may  be 
made  either  in  the  realization  of  assets  or  in  the  liquida- 
tion of  the  liabilities.  The  expenses  of  the  receivership 
or  trusteeship  also  form  items  that  must  be  considered  in 
determining  the  final  net  result  of  the  receiver's 
activities. 

METHOD  OF  CONSTRUCTION 

When  the  trustee's  duties  are  merely  those  of  realiza- 
tion and  liquidation  of  a  business,  the  preparation  of  this 
account  is  not  a  difficult  matter.  Under  such  circum- 
stances the  account  is  constructed  as  follows: 

1.  Debit  the  account  with  the  book  value  of  the  assets 
to  be  realized. 

2.  Debit  it  with  any  new  assets  jvhich  may  have  been 
discovered  after  the  preparation  of  the  statement 
of  affairs. 

3.  Credit  the  account  with  the  liabilities  to  be  liqui- 
dated. 

4.  Credit  it  with  any  new  liabilities  discovered  after 
the  presentation  of  the  statement  of  affairs. 

5.  Debit  the  account  with  the  amounts  paid  to  liqui- 
date liabilities. 

6.  Debit  it  with  the  book  value  of  the  liabilities  not 
liquidated. 

7.  Credit  the  account  with  amounts  actually  realized 
on  sales  of  assets. 

8.  Credit  it  with  the  book  value  of  assets  not  realized. 

9.  Debit  the  account  with  all  the  expenses  of  realiza- 
tion and  liquidation. 

10.  The  balance  of  this  account  represents  the  profit  or 
loss  on  realization  and  liquidation. 


Special  Forms  of  Statements 


385 


The  difference  between  the  book  value  of  the  assets 
which  were  sold  and  the  actual  realized  price  does  not 
appear  in  this  statement,  except  in  the  final  figure  of  total 
profit  or  total  loss,  the  details  of  which  should  be  pre- 
sented in  a  supplementary  statement  or  exhibit. 

An  illustration  of  the  manner  in  which  this  account  is 
constructed  is  offered  in  the  following  skeleton  form : 

SKELETON  OF  EEALIZATION  AND  LIQUIDATION  ACCOUNT 


Assets  to  Be  Kealized 


Liabilities  to  be  Liquidated 
$.... 


New  Assets  Discovered 
..$.. 


New  Liabilities  Discovered 
$.. 


Liabilities  Liquidated 

..$.. 


Assets  Kealized 


Liabilities  not  Liquidated 
$ 


Assets  not  Eealized 
$... 


Expenses  of  Eealization  and 

Liquidation 
$ 


Loss  on  Realization  and 
Liquidation $ . 


At  least  one  excellent  authority  (Professor  William 
Morse  Cole)  says  that  because  of  the  diverse  elements 
entering  into  the  statement  of  realization  and  liquidation 


386  Principles  of  Accounting 

a  separate  account  should  be  opened  for  each  of  the  three 
elements. 

1.  Realization. 

2.  Liquidation. 

3.  Expense  of  liquidation. 

But  when  a  Eealization  and  Liquidation  Account  is 
called  for  in  a  C.  P.  A.  examination,  the  complete  state- 
ment is  the  one  generally  desired,  and  the  examinee 
should  not,  unless  so  instructed,  prepare  it  in  the  form 
of  three  separate  accounts. 

RECEIVER'S  OPERATIONS 

This  statement  was  probably  never  intended  to  do  more 
than  cover  the  various  steps  in  realization  and  liquidation, 
but  C.  P.  A.  examiners  have  found  it  worth  while  to 
extend  its  scope  to  include  those  cases  where  the  receiver 
or  trustee  continues  to  operate  the  business  for  the  benefit 
of  the  creditors,  making  either  a  net  profit  or  a  loss  and 
finally  turning  the  business  back  to  its  original  owners. 
This  complexity  makes  it  difficult  and  awkward  to 
construct  an  illuminating  realization  and  liquidation 
statement.  Probably  the  best  way  to  handle  such  a 
problem  is  to  include,  in  the  statement,  a  new  section 
headed  "Supplementary  Charges''  and  "Supplementary 
Credits."  All  the  items  of  expense  and  income  are 
entered  as  supplementary  items,  and  the  net  result  of 
the  trustee's  realization,  liquidation,  and  trading  activi- 
ties is  shown  in  the  one  figure  of  net  profit  or  net  loss. 

Such  a  figure,  of  course,  means  very  little  without  a 
thorough  analysis,  and  for  this  reason  the  statement  is 
usually  accompanied  by  a  supplementary  exhibit,  showing 
in  detail  the  items  which  contribute  to  the  profit  or  loss. 


Special  Forms  of  Statements  387 

Another  way  of  insuring  the  production  of  an  enlight- 
ening statement  is  to  make  separate  schedules  or  exhibits 
for  the  various  phases  of  the  trustee's  activities  and  to 
bring  them  all  together  in  a  summary  statement. 

TREATMENT  OF  CASH 

It  will  be  noted  that  cash  is  usually  not  shown  in  the 
statement  of  realization  and  liquidation,  since  cash  is 
an  item  which  is  already  realized.  Some  accountants, 
however,  include  it  on  both  sides  of  the  account.  On  the 
debit  side  it  is  included  under  the  heading  of  "Assets 
to  be  Realized ' '  and  on  the  credit  side  under  the  heading 
of  "Assets  Realized. " 

PKOBLEM  ON  THE  REALIZATION  AND  LIQUIDATION  ACCOUNT 

(Adapted  from  the  Michigan  C.  P.  A. 
Examination,  June,  1908) 

The  firm  of  Robinson  and  Hart  became  financially 
embarrassed,  and  a  trustee  was  appointed  January  1, 
1914,  to  take  charge  of  their  affairs  for  the  benefit  of 
creditors. 

On  that  date  (January  1,  1914)  the  financial  condition 
was  shown  by  their  balance  sheet  as  follows : 

Assets 

Cash  on  Hand  and  in  Bank $  1,006.50 

Notes    Keceivable 18,000.00 

Accounts  Keceivable 5,000.00 

Merchandise    4,220.18 

Plant 16,000.00 

Eeal   Estate 10,000.00 


$54,226.68 


388  Principles  of  Accounting 

Liabilities 

Accounts  Payable $10,000.00 

Notes  Payable 6,000.00 

Notes  Keceivable  Discounted 10,000.00 

Mortgage  on  Eeal  Estate 8,000.00 

Mortgage   on   Plant 13,000.00 

Taxes    315.00 

Eobinson— Capital   3,455.84 

Hart— Capital 3,455.84 


$54,226.68 

In  order  to  realize  on  all  assets  advantageously, 
the  trustee  purchased  merchandise  to  the  amount  of 
$10,000.00,  and  during  the  year  collected  $21,350.00  cash 
on  sales.  The  accounts  receivable  realized  $3,950.00. 
Of  the  notes  receivable  entered  in  the  balance  sheet  as 
$18,000.00  there  was  on  hand  only  $8,000.00.  the  balance 
of  $10,000.00  having  been  discounted  with  the  bank  and 
represented  on  the  liability  side  by  the  item  notes  receiv- 
able discounted.  The  $8,000.00,  notes  on  hand,  realized 
the  full  sum,  while  of  the  $10,000.00  discounted  with  the 
bank  only  70%  could  be  realized,  the  balance  being  lost. 

The  notes  payable,  the  taxes,  and  the  interest  on  mort- 
gages (5%%)  were  paid  in  the  course  of  settlement,  and 
one-half  of  the  accounts  payable  were  also  paid. 

Current  expenses  were  as  follows : 

Salaries   $1,000.00 

Office   Expenses 800.00 

Legal  Fees 1,200-00 

Trustee 's  Commission 2,000.00 

During  the  year  the  withdrawals  for  private  use  by  the 
owners  amounted  to  $1,000.00  each.  On  January  1, 1915, 
the  trustee  surrendered  charge  of  the  estate  and  paid  over 
the  cash  balance  on  hand.  There  remains  on  that  date 
merchandise  on  hand,  $5,600.00. 

Prepare  a  realization  and  liquidation  account,  a  trus- 
tee's cash  account,  and  a  balance  sheet  of  the  estate  at 
termination  of  the  trust. 


Special  Forms  of  Statements 


389 


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390 


Principles  of  Accounting 


EXHIBIT  A 

STATEMENT  OF  TRUSTEE  Js  TRADING 
For  the  Period  Ending  December  31,  1914 

Total  Sales $21,350.00 

Merchandise  Inventory,  Jan.  1,  1914 $  4,220.18 

Merchandise   Purchases 10,000.00 


$14,220.18 
Less — Merchandise  Inventory,  Jan.  1,  1915 5,600.00         8,620.18 


Gross  Profit $12,729.82 

Salaries    $  1,000.00 

Interest  on  Mortgages   (5%%  on  $21,000.00) 1,155.00 

Office  Expenses 800.00        2,955.00 


Net    Profit $  9,774.82 


EXHIBIT  B 

STATEMENT  OP  TRUSTEE  's  CASH  EECEIPTS  AND  DISBURSEMENTS 
Presented  January  1,  1915 


1914 

Jan.  1     On  Hand $  1,006.50 

Sales    21,350.00 

Accounts    Eeceiv- 

able   3,950.00 

Notes    Eeceivable     8,000.00 


$34,306.50 

1915 

Jan.  1     Balance   $1,836,50 


1914 

Purchases $10,000.00 

Payment  to  Bank  3,000.00 
Notes  Payable..  6,000.00 
Accounts     Paya- 
ble     5,000.00 

Taxes   315.00 

Interest  on  Mort- 
gages      1,155.00 

Salaries 1,000.00 

Office    Expenses.  800.00 

Legal  Fees 1,200.00 

Trustee 's      Com- 
missions     2,000.00 

Withdrawals   ...  2,000.00 

Dec.  31     Balance  1,836.50 


$34,306.50 


Special  Forms  of  Statements 


391 


COMPARATIVE  BALANCE  SHEETS  OF  ROBINSON  AND  HABT 

Increases 

Assets                                             Jan.  1,  1914  Jan.  1,  1915         and 

Decreases 

Cash     $  1.006.50  $  1,836.50     $      830.00 

Notes  Receivable    8.000.00  8,000.00 

Accounts    Receivable 5,000.00  5,000*00 

Merchandise    4.220.18  5.600.00         1,379.82 

Plant    16,000.00  16,000.00 

Real    Estate 10.000.00  10,000.00 

Total   Assets .$44.226.68  $33,436.50           10,790.18 

Liabilities 

Accounts   Payable $10,000.00  $  5,000.00            5,000.00 

Notes   Payable 6.000.00  6,000.00 

Mortgage  on  Real  Estate 8,000.00  8,000.00 

Mortgage  on  Plant 13,000.00  13,000.00 

Taxes   315.00  S15.00 

$37.315.00 

Additional  Liability  Discovered 3,000.00  S.000.00 

Total    Liabilities .S40.3ir>.no  S2r>.000.00          14,315.00 

Net  Worth 

Robinson — Capital     $  3,455.84 

Less — %  of  Additional  Liability  Discovered..      1.500.00 

Robinson— Capital,  Jan.  1,  1914 .$  1,955.84  $  1,955.84 

Add— %  of  Profits  (%  of  $5,524.82) 2.762.41 

$  4,718.25 

Less — Withdrawal     1,000.00 

Robinson— Capital,  Jan.  1,  1915 $  3.718.25 

Hart — Capital    $  3,455.84 

Less— %  of  Additional  Liability  Discovered..      1,500.00 

Hart — Capital,  Jan.  1,  1914 .$  1.955.84  $  1,955.84 

Add—  %  of  Profits  ( %  of  $5,524.82) 2,762.41 

$  4,718.25 

Less — Withdrawal    1,000.00 

Hart — Capital,  Jan.  1,  1915 $  3.718.25 

Summary 

Total     Assets $44,226.68  $33,436.50 

Total    Liabilities 40,315.00  26,000.00 

Net   Worth .$  3.911.68  $  7.436.50 

Represented  by 

Robinson — Capital     $  1,955.84  $  3,718.25 

Hart— Capital    1,955.84  3,718.25 

$  3,911.68  $  7,436.50 


392 


Principles  of  Accounting 
EXHIBIT  c 


Loss  on  Eealization  (Accts. 

Bee.)    $1,050.00 

Expenses  and  Fees 3,200.00 

Net  Profit  (as  per  Kealiza- 
t  i  o  n  and  Liquidation 
Statement  5,524.82 

$9,774.82 


Profit  on  Trustee 'a  Trading 

as  per  Exhibit  A $9,774.82 


$9,774.82 

Net  Profit  as  per  Balance 

Sheet $5,524.82 


COMMENTS   ON    THE    SOLUTION 

This  problem  is  a  very  fair  illustration  of  the  type  of 
problems  which  are  required  by  C.  P.  A.  examiners.  In 
the  solution  it  will  be  noted  that  cash  on  hand  was  in- 
cluded on  both  sides  of  the  account,  although  this  was 
not  necessary.  The  treatment  of  the  notes  receivable 
discounted  is  worthy  of  some  comment.  It  is  assumed 
in  the  solution  that  the  $3,000.00  loss  is  discovered  by  the 
receiver.  This  loss  forms  a  real  liability,  since  it  must 
be  paid  to  the  bank.  The  Notes  Eeceivable  Account 
might  be  swelled  by  the  $3,000.00  worth  of  bad  notes, 
which  were  returned  by  the  bank,  and  then  this  $3,000.00 
wiped  off  in  realization.  This  method  would  be  perfectly 
proper,  although  the  solution,  as  given,  seems  a  little 
clearer.  The  treatment  of  the  supplementary  charges 
and  supplementary  credits  will  be  immediately  under- 
stood upon  examination  of  the  statement. 

Another  solution  of  this  problem  in  a  somewhat  dif- 
ferent form  is  shown  herewith,  it  being  thought  desirable 
to  indicate  at  least  two  of  the  standard  methods  of 
preparing  such  exhibits. 


Special  Forms  of  Statements 


393 


EXHIBIT  A 


STATEMENT  OF  KEALIZATION  AND  LIQUIDATION  BY  TRUSTEE  FOE  THE  FIEM  OP 
EOBINSON  AND  HART 

January  1,  1915 
Assets  to  be  Kealized 

Cash  $  1,006.50 

Notes  Eeceivable $18,000,00 

Less — N  o  t  e  s    Eeceivable    Dis- 
counted       10,000.00         8,000.00 

Accounts  Eeceivable 5,000.00 

Merchandise    4,220.18 

Plant    16,000.00 

Eeal    Estate 10,000.00     $44,226.68 

Assets  Eealized 

Cash    $  1,006.50 

Notes   Eeceivable 8,000.00 

Accounts    Eeeeivable 3,950.00     $12,956.50 

Assets  not  Eealized 

Merchandise $  4,220.18 

Plant    16,000.00 

Eeal    Estate 10,000.00       30,220.18       43,176.68 

Loss  on  Eealization  of  Assets $  1,050.00 

Liabilities  to  be  Liquidated 

Notes    Payable $  6,000.00 

Accounts    Payable 10,000.00 

Mortgages  on  Eeal  Estate 8,000.00 

Mortgages    on   Plant 13,000.00 

Taxes    315.00 

$37,315.00 

Liability  Discovered   (Notes  Eeceiv- 
able   Discounted) 3,000.00     $40,315.00 

Liabilities  Liquidated 

Notes  Payable $  6,000.00 

Accounts  Payable 5,000.00 

Notes     Eeceivable     Dis- 
counted       3,000.00 

Taxes  315.00     $14,315.00 


394  Principles  of  Accounting 

Liabilities  not  Liquidated 

Accounts  Payable $  5,000.00 

Mortgage  on  Keal  Estate     8,000.00 

Mortgage  on  Plant 13,000.00       26,000.00       40,315.00 


Gain  on  Liquidation None 


$  1,050.00 
Expenses  and  Fees  of  Trusteeship 

Legal  Fees $  1,200.00 

Trustee 's    Commission 2jOOO.OO         3,200.00 


Total  Loss  on  Eealization  and  Liquidation $  4,250.00 

(Transferred  to  Summary) 

EXHIBIT  B 

TRUSTEE'S  TRADING  AND  PROFIT  AND  Loss  STATEMENT 
For  the  Year  Ending  December  31,  1914 

Total  Sales  (for  cash) $21,350.00 

Inventory  of  Merchandise,  Jan.  1,  1914 $  4,220.18 

Add — Merchandise  Purchases 10,000.00 


$14,220.18 
Deduct — Inventory  of  Merchandise,  Dee.  31,  1914. .     5,600.00 


Cost  of  Goods  Sold 8,620.18 


Gross  Profit $12,729.82 

Deduct — Expenses 

Salaries .$  1,000.00 

Interest  on  Mortgages 1,155.00 

Office  Expense 800.00        2,955.00 


Net  Profit  (Transferred  to  Summary) $  9,774.82 


EXHIBIT  C 

TRUSTEE'S  SUMMARY  STATEMENT 

Net  Profit  (from  Exhibit  B) $9,774.82 

Loss  on  Eealization  and  Liquidation  (from  Exhibit  A) 4,250.00 

Amount  Creditable  to  Partner's  Capital  Accounts $5,524.82 


Special  Forms  of  Statements  395 

Whatever  metho.d  of  solving  such  problems  is  used, 
the  exhibit  is  not  complete  without  a  statement  of  the 
trustee's  cash  receipts  and  disbursements  and  a  state- 
ment of  the  resources  and  liabilities  at  the  time  of  his 
discharge.  The  preparation  of  these  is  a  simple  matter, 
since  all  the  data  are  contained  in  the  problem  itself  and 
all  that  is  needed  is  a  careful  picking-out  of  the  items.  It 
will  be  noted  that  all  these  statements  " support"  one 
another,  so  that  an  error  may  not  be  made  in  one  schedule 
without  being  caught  by  some  of  the  others. 

It  is  always  a  good  idea  to  present  the  final  resources 
and  liabilities  in  comparative  form,  although  the  ordinary 
account  form  would  be  proper.  It  is  always  of  interest 
to  compare  the  statements  just  before  and  just  after  the 
trusteeship,  and  the  comparative  form  showing  the  in- 
creases and  decreases  of  the  various  items  would  prove 
most  illuminating. 

TEST  QUESTIONS 

1.  (a)  What  is  a  statement  of  affairs? 

(b)  What  is  its  purpose? 

(c)  For  whom  and  by  whom  is  it  prepared? 

2.  (a)  What  is  a  deficiency  account? 

(b)  What  relation  does  it  bear  to  the  statement  of  affairs? 

3.  (a)  What  is  a  statement  of  realization  and  liquidation? 

(b)  What  relation  does  it  bear  to  the  statement  of  affairs 
and  the  deficiency  account?' 

(c)  How  is  it  constructed ? 

(d)  For  whom  is  it  constructed? 


CHAPTER  XIV 

THE  HOLDING  COMPANY  AND  THE  CONSOLIDATED 
BALANCE  SHEET 

During  recent  years  a  new  form  of  organization  has 
been  developed,  bringing  with  it  accounting  problems  of 
importance.  This  organization  is  what  is  familiarly 
known  as  a  "trust"  or  "holding  company."  Broadly 
speaking,  there  are  two  ways  that  a  "trust"  may  be 
formed : 

1.  A  new  corporation  may  purchase  all  the  assets  of  a 
number  of  other  corporations  engaged  in  the  same 
general  line  of  business. 

2.  A  new  corporation  may  exchange  its  stock  for  the 
stock  of  other  corporations. 

The  first  case  presents  no  accounting  difficulties.  The 
second  method  of  organization  deserves  the  very  closest 
attention,  because  of  the  fact  that  the  various  units,  i.  e., 
subsidiary  companies,  retain  their  legal  individuality. 
Each  subsidiary  corporation  is  linked  direct  to  the  parent 
corporation  through  capital  stock  control,  but  ordinarily 
there  is  no  such  relation  between  the  various  subsidiary 
companies,  although  there  may  be. 

Such  combinations  or  holding  companies  are  formed 
(1)  for  the  purpose  of  acquiring  control  of  the  capital 
stock  of  operating  companies  and  (2)  for  the  purpose 
of  receiving  as  their  own  income,  incomes  of  the  sub- 

396 


Holding  Companies  397 

sidiary  organizations,  which  can  probably  be  considerably 
increased  because  of 

1.  Reduced  cost  of  operation. 

2.  Elimination  of  competition. 

3.  Cheaper  financing. 

Holding  corporations,  strictly  speaking,  exercise  nti 
function  except  that  of  holding  the  stock  of  other  cor- 
porations, but  there  is  no  reason  why  a  holding  company 
may  not,  in  fact,  they  do  frequently,  engage  in  certain 
operating  activities. 

THE  ACCOUNTING  PROBLEMS 

In  a  discussion  of  the  broad  general  accounting  features 
of  such  holding  companies  and  their  subsidiaries,  it  must 
be  borne  in  mind  that  there  are  two  kinds  of  holdings : 

1.  A  holding  company  may  possess  only  a  very  small 
proportion  of  the  total  outstanding  stock  of  the 
subsidiary. 

2.  It  may  own  all  or  practically  all  the  outstanding 
capital  stock  and  thus  exercise  complete  control. 

In  the  first  case  the  stock  holdings  are  considered 
merely  as  investments  or,  possibly,  as  a  lever  for  influ- 
ence, and  no  special  points  of  interest  are  involved;  but 
in  the  second  case  where  a  sufficient  amount  of  the  stock 
is  owned  to  carry  control,  some  of  the  most  difficult 
problems  of  accounting  are  to  be  noted. 

In  a  discussion  of  holding  companies  and  their  sub- 
sidiaries, it  is  likewise  well  to  get  in  mind  the  fact 
that  from  the  operating  standpoint  (disregarding  for  a 
moment  the  legal  point  of  view)  the  entire  organization 
may  be  considered  as  nothing  more  than  a  series  of 


398  Principles  of  Accounting 

separate  establishments  or  plants  under  the  same  man- 
agement and  ownership.  When  looked  upon  in  this  light, 
certain  accounting  principles,  it  can  be  clearly  seen,  will 
apply  that  would  not  be  appropriate  if  each  subsidiary 
were  to  be  considered  as  a  separate  self-contained  and 
independent  unit. 

If  the  various  subsidiaries  are  considered  merely  as 
separate  elements  in  the  same  organization,  it  is  clear 
that  any  transactions  between  two  such  subsidiaries  will 
have  no  effect  upon  the  status  of  the  organization  con- 
sidered as  a  whole.  In  illustration  of  this  point  we  can 
do  no  better  than  quote  the  very  apropos  illustration 
which  is  to  be  found  in  Esquerre's  Applied  Theory  of 
Accounts. 

If  a  father  had  intrusted  the  management  of  $300,000.00  of 
personal  property  to  three  of  his  sons,  in  equal  amount,  they  to 
enjoy  the  income  of  the  trust  estate,  it  might  be  that,  at  the  end 
of  a  given  period,  the  marshaling  of  the  units  of  the  principal  of 
the  trust  fund  might  show  that  John  had  loaned  $50,000.00  to 
James,  who  in  turn  had  loaned  $25,000.00  to  Charles.  But  the 
balance  sheets  submitted  by  the  three  trustees  would  not  in  the 
aggregate  reveal  anything  of  great  importance  to  the  father, 
since  the  fund  remains  intact.  If  James  repaid  John  the 
$50,000.00  which  he  owes  him  and,  in  turn,  Charles  repaid  to 
James  the  $25,000.00  loaned  by  the  latter,  John's  balance  sheet 
would  be  richer  in  liquid  assets,  while  that  of  James  and  Charles 
would  be  poorer  in  liquid  assets  and  richer  in  reduction  of  lia- 
bilities; but  the  father  would  not  have  one  cent  more.  If,  then, 
the  components  of  a  holding  company,  as  represented  by  the  stock 
which  the  latter  controls,  have  been  financed  one  by  the  other, 
all  the  debts  of  an  individual  member  (one  such  subsidiary), 
which  are  the  assets  of  another  must  be  omitted  from  a  statement 
endeavoring  to  show  the  exact  status  of  the  assets  controlled  by 
the  parent  company. 


Holding  Companies  399 

TRUE  BALANCE  SHEET 

The  true  balance  sheet  of  a  holding  company  is  or- 
dinarily not  very  illuminating.  On  the  asset  side  it 
contains  practically  nothing  but  securities  owned,  and 
on  the  liability  side  very  little  but  its  own  capital  stock 
outstanding.  Nor  are  the  balance  sheets  of  the  subsidiary 
companies  as  informative  as  they  should  be.  From  a 
study  of  them  it  is  difficult,  if  not  impossible,  to  get  that 
adequate  survey  of  the  business  as  a  whole  which  would 
be  desired  by  the  stockholder  of  the  holding  company. 
Such  a  stockholder  feels  that  so  far  as  true  ownership 
is  concerned  all  the  phases  of  the  business  are  simply 
phases  of  a  single  enterprise  and  that  he  is,  therefore, 
entitled  to  obtain  his  information  from  that  standpoint. 

CONSOLIDATED  BALANCE  SHEET 

It  is  clear  that  some  special  form  of  exhibit  or  statement 
must  be  prepared  in  order  to  satisfy  the  wishes  of  the 
holding  company's  own  stockholders.  Such  a  statement 
cannot  be  a  balance  sheet,  in  the  strict  sense  of  the  word, 
but  custom  has  sanctioned  its  use  in  this  particular  in- 
stance, since  the  term  "  consolidated  balance  sheet "  has 
a  distinct  meaning  peculiar  to  itself.  It  may  be  well  to 
say  at  the  outset  of  the  discussion  that  the  consolidated 
balance  sheet  probably  has  no  legal  standing  at  the 
present  time,  but  it  is  almost  universally  employed  by 
every  large  holding  company.  The  consolidated  balance 
sheet  is  made  up  by  properly  combining,  according  to  the 
certain  fundamental  accounting  principles,  the  several 
balance  sheets  of  the  various  corporations  making  up  the 
organization.  The  consolidated  balance  sheet  shows  the 
assets  of  the  subsidiary  companies  as  the  assets  of  the 
holding  company,  thus  for  balance  sheet  purposes 


400  Principles  of  Accounting 

eliminating  and  disregarding  the  legal  distinct  individu- 
ality of  the  subsidiary  corporations. 

ELIMINATION  OF  INTEKRELATIONS 

In  order  to  form  this  consolidated  showing,  it  is 
necessary  to  eliminate  all  the  relations  of  constituent 
companies  with  each  other.  Assume  that  Company  "A" 
is  a  holding  corporation  owning  the  entire  capital  stock 
of  Corporation  "B,"  Corporation  "C,"  and  Corporation 
"D."  To  get  a  consolidated  balance  sheet  it  would  be 
necessary  to  merge  the  balance  sheets  of  these  four  cor- 
porations, and  if  a  true  showing  is  to  be  desired,  all 
intercompany  relations  must  be  eliminated.  Company 
"B"  may  owe  Company  "C"  $50,000.00,  yet  from  the 
standpoint  of  the  enterprise  as  a  whole  this  fact  is  im- 
material. From  the  standpoint  of  an  individual,  it  does 
not  make  any  difference  which  pocket  his  money  is  in,  but 
if  an  account  is  to  be  kept  with  a  certain  pocket,  the  matter 
of  transference  of  funds  from  one  pocket  to  the  other 
is  of  importance. 

We  may,  therefore,  lay  down  the  rule  that  in  the  con- 
struction of  a  consolidated  balance  sheet  the  balance 
sheets  of  all  the  companies  forming  a  complete  whole  are 
to  be  merged  into  one,  but  that  all  intercompany  relations 
are  to  be  eliminated  in  the  process.  In  the  formation  of 
a  consolidated  balance  sheet  all  the  items  of  cash  owned 
by  each  of  the  companies  will  be  added  together,  their 
sum  representing  the  total  cash  on  hand.  In  a  similar 
way  all  the  items  of  merchandise  on  hand  will  be  deter- 
mined and  the  total  used  in  the  consolidated  balance 
sheet. 

The  item  of  accounts  receivable,  however,  would  not 
necessarily  be  treated  in  this  way.  It  would  be  necessary 
for  the  accountant  to  scrutinize  these  various  items  care- 


Holding  Companies 


401 


fully  to  find  out  whether  an  account  receivable  of  one 
company  was  not  offset  by  an  account  payable  of  another. 
If  this  were  found  to  be  true,  it  would  be  necessary  to 
eliminate  them  both,  showing  only  as  accounts  receivable 
the  total  amount  due  all  the  companies  from  outside 
sources. 

WOEKING  FORM 

As  an  aid  to  making  up  consolidated  balance  sheets,  it 
is  customary  to  use  a  working  form  as  follows : 


Elimination 

Accounts 

Company 
-A" 

Company 

Company 
"C" 

of 
Inter- 

Total 

relations 

The  form  is  self-explanatory,  simply  providing  a  con- 
venient means  of  making  the  required  elimination. 

The  principal  points  to  be  noted  in  the  preparation  of 
consolidated  balance  sheets  are  in  connection  with  good- 
will, surplus,  and  the  minority  interests. 

GOODWILL 

The  goodwill  item  which  appears  on  the  consolidated 
balance  sheet  is  the  algebraic  sum  of  the  several  items 
of  goodwill  purchased  by  the  holding  company  from  the 
several  subsidiary  companies.  If  the  price,  whether  in 
cash  or  in  capital  stock,  which  is  paid  for  the  stock  of 
another  company  should  be  greater  than  the  sum  of  the 
par  value  of  such  stock  and  its  proportion  of  surplus, 
the  difference  is  the  amount  which  is  properly  chargeable 
to  the  Goodwill  Account  on  the  consolidated  balance  sheet. 


402  Principles  of  Accounting 

This  principle  has  for  its  basis  merely  ordinary  common 
sense.  If  the  purchase  price  is  greater  than  the  total 
net  worth,  as  exhibited  in  the  balance  sheet  of  the  pur- 
chased company,  it  is  assumed  that  the  assets  of  that 
company  have  been  stated  at  a  figure  which  is  really 
under  their  true  value.  It  cannot  be  held  that  the  pur- 
chasing company  is  guilty  of  the  folly  of  knowingly 
paying  more  for  the  stock  than  it  is  worth.  The  excess 
price  which  is  paid  is,  therefore,  held  to  be  for  the 
purchase  of  goodwill. 

If,  on  the  other  hand,  the  purchase  price  is  less  than 
the  market  value  of  the  stock,  as  shown  by  the  balance 
sheet,  it  may  be  assumed  that  the  balance  sheet  figures  are 
inflated,  and  such  a  discount  would  ordinarily  be  credited 
to  the  Goodwill  Account  on  the  consolidated  balance  sheet. 
It  might  happen  that  the  total  credits  to  Goodwill  were 
in  excess  of  its  total  charges,  although  this  would  be 
unusual.  In  such  a  case  at  least  one  authority  recom- 
mends that  the  excess  credit  balance  be  credited  to  the 
Capital  Surplus  Account.  It  would  be  equally  proper  to 
credit  it  to  a  valuation  account,  since  it  merely  serves  as 
an  offset  to  inflated  asset  values.  Whatever  title  is  used, 
it  should  clearly  label  the  amount  as  being  unavailable 
for  dividends. 

In  addition  to  the  various  goodwill  components-  ob- 
tained by  charging  the  excess  of  purchase  price  over 
book  value  of  capital  stock  of  the  purchased  companies, 
there  must  also  appear  as  additional  charges  to  that 
account  the  various  items  of  goodwill  which  appeared 
on  the  balance  sheets  of  the  underlying  companies  at  the 
time  they  were  taken  over.  Such  previous  goodwill  items 
are  frequently  merged  with  other  items  under  the  head 
of  property. 

As  an  illustration  of  the  goodwill  treatment,  we  may 


Holding  Companies 


403 


assume  that  Corporation  "A"  has  purchased  all  the 
outstanding  capital  stock  of  Corporations  "B,"  "C," 
and  "D."  Disregarding  other  elements  appearing  in 
their  balance  sheets,  we  find  that  Corporation  "B"  shows 
goodwill  of  $10,000.00,  that  its  outstanding  capital  stock 
is  $50,000.00,  and  that  its  total  surplus,  both  appropriated 
and  free,  is  $7,000.00.  Corporation  "C"  has  a  capital 
stock  of  $25,000.00,  and  a  surplus  of  $8,000.00,  and  Cor- 
poration "D"  has  goodwill  of  $5,000.00,  capital  stock  of 
$15,000.00,  and  a  surplus  of  $2,000.00.  Corporation  "  A  " 
paid  $60,000.00  for  the  total  stock  of  Company  "B," 
$31,000.00  for  Company  "C,"  and  $20,000.00  for  Com- 
pany "B." 


Com- 
pany 

B 
C 
D 


Goodwill    Capital   Stock     Surplus 


$10,000.00 

None 

5,000.00 


$50,000.00 
25,000.00 
15,000.00 


$7,000.00 
8,000.00 
2,000.00 


Price   Paid 

by 
Company  A 

$60,000.00 
31,000.00 
20,000.00 


EXCESS  OB  DEFICIT 
Excess          Deficit 
$3,000.00 

$2,000.00 
3,000.00 


From  the  foregoing  facts  it  is  required  to  determine 
what  the  item  of  goodwill  on  the  consolidated  balance 
sheet  would  be. 


Charges  to  Goodwill 

Co.  B $10,000.00 

"     B 3,000.00 

"     D 5,000.00 

"    D 3,000.00 


$21,000.00 
Balance $19,000.00 


Credits  to  Goodwill 

Co.   C $  2,000.00 

Balance 19,000.00 


$21,000.00 


From  the  calculation  as  shown  it  is  plain  that  the 
goodwill  item  appearing  on  the  consolidated  balance  sheet 
will  be  $19,000.00.  This  item  of  goodwill,  which  has  just 
been  determined,  would  not  actually  appear  anywhere 


404 


Principles  of  Accounting 


Chart  illustrating  condition  before  stock  transfer 


Stockholder* 


Stockholder* 


HOLDING 
CORPORATION 
(owns  majority 
stock  in  3 
subsidia- 
ries.) 


Chart  illustrating  condition  after  the  stockholders  in  Company  "A,"  Com- 
pany "B,"  and  Company  "C"  exchange  their  stock  for  stock  of  the  new  holding 
corporation. 

P!G.  74. — Charts  Illustrating  Lines  of  Stock  Control  of  a  Holding  Company 


Holding  Companies 


405 


on  the  books  of  account  either  of  the  holding  company 
or  of  any  of  these  subsidiary  companies.  Ten  thousand 
dollars  of  it  would  appear  in  the  Ledger  of  Company  B 
as  an  asset  and  $5,000.00  of  it  in  the  Ledger  of  Company 
D  as  an  asset,  but  the  remainder  could  nowhere  be  found 
as  a  book  item.  The  reason  is  that  the  stock  holdings 
of  the  parent  company  are  shown  at  their  cost  price, 
while  the  general  books  of  the  subsidiary  companies  will 


Stockholder,  in  P»«n»  Company 


HOLDING 
CORPORATION 
(owns  majority 
stock  in  3 
subsidia- 
ries.) 


Chart  illustrating  condition  if  parent  company  is  able  to  buy  only  controlling 
interest  in  Company  "A,"  Company  "B,"  and  Company  "C."  A  consolidated 
balance  sheet  must  not  overlook  the  legal  rights  of  stockholders  marked  "x," 
"y,"  and  "z" 

FIG.  74. — Continued 


show  no  changes.  The  only  effect  so  far  as  their  books 
are  concerned  is  the  change  in  stockholders,  which  will 
be  registered  in  the  stock  ledger  entry. 

In  the  foregoing  discussion  it  has  been  assumed  that 
the  holding  company  has  purchased  all  the  stock  of  its 
subsidiaries,  but  in  practice  this  rarely,  if  ever,  obtains. 


406  Principles  of  Accounting 

MINORITY  INTERESTS 

Usually  the  holding  company  is  unable  to  purchase  all 
outstanding  shares,  although  it  usually  can  obtain  enough 
to  exercise  a  controlling  interest.  (See  charts  in  Figure 
74.)  The  minority  stockholders,  i.  e.,  those  who  have 
not  exchanged  their  holdings  for  stock  in  the  parent 
company,  must  not  be  ignored  in  the  consolidated  balance 
sheet.  Not  only  must  the  stock  belonging  to  outsiders 
be  set  up  as  a  separate  item  on  the  consolidated  balance 
sheet,  but  also  the  amount  of  surplus  which  belongs  to 
those  stockholders.  This  is  a  matter  of  simple  arith- 
metical calculation.  The  amount  of  surplus  to  be  appor- 
tioned to  minority  stockholders  is  the  same  percentage 
of  the  total  surplus  of  the  subsidiary  company  as  the 
minority  stockholders'  interest  is  of  the  total  outstanding 
stock  of  the  subsidiary.  There  are  at  least  three  ways 
of  exhibiting  the  facts  on  the  Consolidated  Balance 
Sheet. 

First  Method 
CONSOLIDATED  BALANCE  SHEET 

Assets $ Liabilities $ 

Capital  Stock  of 

holding      c  o  m  - 

pany    $ 

Proportion     o  £ 

Surplus 


Minority    Stock- 
holders '  Interest 
Capital    stock 
Proportion  of 
Surplus    


Assets 


Holding  Companies 

Second  Method 
CONSOLIDATED  BALANCE  SHEET 

$ Liabilities 

Capital  Stock 

Capital  Stock 
of  holding 
company  . . . .  \ 
Subsidiaries ' 
Stock  Out- 
standing .... 


Surplus 
Majority     In- 
terest   . 


Minority     In- 
terest   . 


407 


Assets 


Third  Method 
CONSOLIDATED  BALANCE  SHEET 

$ Liabilities  $ . 

Capital    Stock    of    holding 

company 

Subsidiaries '   Stock  Out- 
standing    

Surplus   


This  latter  arrangement  does  not  apportion  the  sur- 
plus; hence  one  of  the  other  two  methods  is  to  be 
preferred. 

INTERCOMPANY  SALES 

Another  interesting  accounting  feature  occurs  in  con- 
nection with  intercompany  transactions  where  there  is  a 
minority  stock  interest.  If  we  regard  the  holding  com- 
pany and  all  its  subsidiaries  as  being  one  undertakingr 
then  it  is  evident  that  the  sales  from  one  subsidiary  to 


408  Principles  of  Accounting 

another  should  contain  no  element  of  profit.  If  this 
principle  is  not  closely  observed,  anticipation  of  profits 
would  result  and  inventories  would  be  inflated  from  the 
viewpoint  of  the  enterprise  as  a  whole.  On  the  other 
hand,  the  minority  stockholders  may  not  be  interested  in 
the  enterprise  as  a  whole,  if  only  stockholders  in  a  particu- 
lar subsidiary.  So  far  as  they  are  concerned  sales  must 
be  made  to  other  subsidiaries  at  a  fair  profit;  otherwise 
they  feel  that  they  have  been  defrauded. 

The  system  of  handling  intercompany  sales,  in  order 
to  meet  both  these  points  of  view,  must  necessarily  be 
very  elaborate.  It  implies  carrying  all  sales,  both  at 
the  cost  and  at  the  selling  price.  This  enables  the  con- 
struction of  consolidated  balance  sheets,  showing  all 
inventories  at  actual  cost  of  production,  and  it  also 
permits  the  preparation  of  subsidiary  companies'  state- 
ments and  balance  sheets,  showing  intercompany  trans- 
actions on  the  basis  of  profitable  selling  prices.  Material 
may  be  passed  from  one  subsidiary  to  another,  and  in  a 
large  organization  there  may  be  eight  or  ten  transactions 
before  the  ultimate  finished  product  is  eventually  sold  to 
outsiders.  Not  until  this  has  actually  been  done  may  the 
various  intercompany  profits  be  actually  shown  as 
"  realized "  from  the  holding  company  viewpoint. 

Another  point  of  interest  in  the  same  connection  occurs 
when  one  subsidiary  sells  material  to  another  for  con- 
struction purposes.  In  previous  chapters  we  have  seen 
that  from  the  standpoint  of  the  undertaking  as  a  whole, 
all  charges  for  new  construction  should  be  strictly  on  a 
cost  basis,  including  no  element  of  profit.  This  same 
principle  holds  true  in  situations  similar  to  the  one  now 
in  discussion,  and  the  price  at  which  materials  are 
charged  to  the  construction  account  of  Corporation  B 
must  be  their  actual  cost  of  production,  although  Cor- 


Holding  Companies  409 

poration  B  paid  for  the  materials  on  the  basis  of  cost 
plus  profit  to  another  subsidiary. 

The  whole  scheme  of  holding  company  accounting  is 
so  vast  that  we  cannot  do  more  than  lay  down  a  few 
general  principles  which  apply.  The  very  size  of  most 
of  our  modern  trusts  necessitates  intricate  and  elaborate 
accounts.  Complicated  as  these  may  appear,  they  have 
no  terrors  for  the  man  who  is  thoroughly  versed  in 
accounting  science,  for  they  are  based  on  the  simple 
unchangeable  accounting  principles. 

TEST  ^QUESTIONS 

1.  (a)  What  is  a  "trust"  in  the  popular  sense? 

(b)   In  what  two  ways  may  a  "trust"  be  formed? 

2.  What  are  the  advantages  of  consolidation? 

3.  What  is  the  difference  between  the  accounting  and  the  legal 
point  of  view  as  regards  holding  companies  ? 

4.  (a)  What  is  a  consolidated  balance  sheet? 

(b)  What  is  its  legal  standing? 

(c)  How  does  it  differ  from  a  true  balance  sheet? 

5.  What  are  the  components  of  "goodwill"  on  a  consolidated 
balance  sheet? 

6.  Illustrate  three  ways  of  exhibiting  proprietary  interest  on 
a  consolidated  balance  sheet. 

7.  What  is  the  accounting  rule  as  to  inter-company  sales? 


INDEX 


Acceptances,  167 
Accountancy,  definition  of,  21 
Accounting  period,  36-38,  131-34 
Accounts 

analysis  of,  26-32 

assets.     See  Assets. 

balance  sheet.     S'ee  Balance  sheet. 

bases  of.   21-52 

controlling.    See  Controlling  accounts. 

corporation.  210-21.  295-344,  372-409 

definition  of,  19,  21 

depreciation.     See   Depreciation. 

double  entry,  3-19.  21,  43-45 

holding  companies,   396-409 

Insolvency.   372-95 

inventories.     See  Inventories. 

journals.     See  Journals. 

liabilities.       See    Liabilities:     Insol- 
vency. 

manufacturing  statement,  233-37 

mixed,   35-36.   116-18 

nominal     and     real.     33.     See     also 
Proprietor's  account. 

partnership.   217-19.   275-94,  317-21 

payable.  42-44,  63-64.     See  also  Lia- 
bilities. 

posting.  40-41,  101-4 

preliminary  survey  of,  1-19 

private  ledger,  79-84 

profit  and  loss.     See  Profit  and  loss 
account. 

proprietor's.      See     Proprietor's     ac- 
count. 

railroad.   253-58,   271.  343 

receivable,  42-44.  62.    See  also  Assets. 

reserves.  221,  301-2.  329-44,  377 

single  entry,  44-45.   152-53 

subsidiary.    See  Subsidiary  accounts. 

surplus.     See  Surplus  account., 

symbolized,  2-19 

the  ledger,  21-23.     tee  also  Ledger. 

trial  balance.     See  Trial  balance. 

two  principal  objects  of.  38 
Accrual.   118.   133-34.  198-99.  325 
Adjusting  entries.  110-12.  118-39,  146- 

54 

Affairs,   statement  of,  372-78 
Allocation  account,  profit  and  loss,  214 
Amortisation 

definition  of,  180 

of  land.  183-84 

of  mines,  323-24 
Analysis  of  accounts.  26-32 
Apportionment  accounts,  265-66 
Appreciation.   179-82,  349 
Articles  of  partnership,  275-77 
Assets 

acceptances,  167 

and  their  valuation.   155-96 

bad  debts.   162-64,  251-52 

bills  receivable,  167 

buildings.     See  Real  estate. 

classification  of.  157,  178-79 


consist  of  property  and  claims,  155- 

56 

current,  157-58,  160-67.  178 
debts  receivable.  6-8.  162-65 
deferred.  48,  132-34,  158.  191,  348 
depreciation  of.     See  Depreciation, 
equipment.     See  fixed, 
expressed  in  terms  of  money.  156-57 
fixed.   157.  178-96 
•     fluctuation  in  value  of.  168-69,  177- 

83,  348-49 

franchises  and  patents,  195 
goodwill,   192-95.  401-5 
investments,  188-91 
intangible,  179,  191-96 
land.     See  Real  estate, 
leaseholds.   186-87 
machinery.   148-52.   187-88,   354-56 
merchandise,  3-19.  27-28.  33-36.  108. 

167.  178 

notes  receivable.   165-66,  200-203 
of  partnerships.  275-94 
organization.    196 
real  estate,  26-27.  178-87 
symbolized.  3-19 
utility  in.   158-60 
valuation  account,   151,   163-64,   329- 

30 

valuation  of 
basis  of,  160 

current  assets.  160-67,  178 
fixed  assets,  147-52.  178-96,  323-24 
working  assets.   167-78 
working,   158,  167-78 
See  also  Accounts ;  Insolvency. 

Bad  debts.  162-64.  251-52 
Balance,   trial.     See  Trial  balance. 
Balance  sheet 

adjusting    entries,     110-12,     118-39. 
146-54 

closing  entries.     See  Closing  entries. 

consolidated,    899-407 

construction  of.   144-47 

definition  of,  37-38,  113.  141-42 

depreciation    in.     147-52.     S'ee    also 
Depreciation. 

effect   of   reserves   on    interpretation 
of.  332-37 

form  of,  113-14,  142-46 

limitations  of.  115-16,  147-52 

receiver's,    372-73 

showing  of  bond  discounts  and  pre- 
miums, 205-10 

who  interested  in.   114-15 

working.    116-39,    145-47 
Bases  of  accounting,  21-52 
Bills  receivable.  167 
Bonds.  184.  188-91,  203-11,  337-41 
Bookkeeping,     definition    of,     21.     See 

also  Accounts. 
"Boston   ledger,"   88-89 
Buildings.     See  Real  estate. 


411 


412 


Index 


Capital 

of  a  corporation,  220-21 

of  a  partnership,  275-94 

See  also  Capital  stock. 
Capital     stock.     220-21.     295-328.     See 

also  Holding  companies. 
Capital  surplus  account,  303,  309-13 
Cash 

as  a  current  asset,  158,  161-62 

how  handled  in  columnar  .lournal. 
55-61 

in  realization  and  liquidation  state- 
ment. 387 

journal,    65-75 

private,  83 

statement  of  receipts  and  disburse- 
ments, 253 

See  also  Accounts. 
Cash  book,  46 
Checks,  161 

Clearing  accounts.   267-74 
Closing    entries,    110-12,    118-20,    125, 

139-40,    147,    153-54,    252-55 
Columnar  journal,  55-61 
Columnar  ledger,  88-89 
Consolidated  balance  sheet,   399-407 
Contingent     liabilities,     200-203,     331, 

335-36,    352-53 
Controlling   accounts 

definition  of,  43,  65 

examples  of,  43-44,  62-63,  263-66 

relation  to  special  journals,  77-78 
Corporations 

capital  stock  in,  295-328.  See  also 
Holding  companies. 

corporate  books.  297-300,  397-409 

definition  of,   219-20,  295-96 

depreciation    in,    324-25.      See    also 
Depreciation. 

discount  on  stock  of.  303 

dividends  of.  297,  300-302,  321-28 

donated  stock  of,  310-13 

holding  companies,   396-409 

insolvency  in.  372-95 

mining  companies,  323-24 

opening  entries  of,  305-10 

partnership  changed  to,  317-21 

premium  on  stock  of,  302-3 

proprietorship  account  of,  220-21, 
300-328.  See  also  Holding  com- 
panies. 

reserves  of,  301-2,  329-44,  377 

surplus  of,  301-3,  309-13 

treasury  stock  of,  303-5,  310-13 

unissued  stock  of,  303-5,  316-17 
Cross-indexing,    104 
Current  assets,  157-67 

bills  receivable,  166 

debts  receivable,  162-65 

merchandise,  166 

money  and  checks,  160-62 

notes  receivable,  165-66 
Current  liabilities,  197-99 
Cycle,  economic,  158-60 

Debit.  21.     See  also  Accounts. 

deferred,  48,  132-34,  158,  191,  348 
Debts  payable.     See  Liabilities. 
Debts  receivable 

bad,   162-64,  251-52 

symbolized,   6-8 

valuation  of.  162-65 


Deferred 

assets,  debits,  or  charges,  48,  132-34, 
158.   191,   348 

liabilities.    133-34.    199-200 
Deficiency  account.  378-83 
Departments.  30-31.  266 

apportioning  expenses  among,  267-74 
Depreciation.  115.  147-52.  179-87.  323- 
24.   330-35,   340-71 

and  fluctuation.  348-49 

as   a    cost,   247-48.   347-48 

causes  of,  349-52 

contingent.   352-53 

in   rnilroads.    370-71 

methods.   149-52.  358-69 

plant  ledger.  353-56 

rate  of,  356-58 

replacements,  353,  369-70 
Disbursements.     See  Cash. 
Discounts 

in  valuation  of  working  assets,  169- 
70 

journal  record  of,  71-75 

on  bonds,  205-7 

on  stock,  303 

symbolized,  5-8 

treatment  of,  in  profit  and  loss  state- 
ment,  248-50 

Distribution   of  expenses,   267-74 
Dividends,  184,  199,  297,  300-302,  321- 

28 

Donated  stock,  310-13 
Double  entry 

confined  to  General  Ledger,  43 

defined,  21 

illustrated,  3-19 

incomplete,  44-45,  152-53 

Economic  cycle,  158-60 
Entry 

double.     See  Double  entry. 

single.   44-45,   152-53 
Errors,  treatment  of.  US,  242-43 
Expenses,  224-27,  259-74 

clearing  accounts  for,  267-74 

Factory  profits,  246-47 
Fixed  assets,  157,  178-96 

buildings.     184-87.     See    also     Real 
estate. 

deferred.  48,  132-34,  158,  191,  348 

franchises  and  patents,  195 

goodwill,  192-95 

intangible,  191-96 

investments,    188-91 

land,  182-84.     See  also   Real  estate. 

machinery,  148-52,  187-88,  354-56 

organization  expense,  196 

See  also  Depreciation. 
Fluctuation 

and  depreciation,  348-49 

in  value  of  fixed  assets.  179-83 

in  value  of  working  assets,   168-69, 

177-78 

Forwarding  the  balance,  28 
Franchises  and  patents,  195 

Goodwill,  192-95,  401-5 

Holding  companies 

accounting  problems   of,   397-4 
consolidated   balance   sheet.   399-4 


Index 


413 


formation  of,  396-97 

goodwill,  401-5 

minority  interests  in,  405-9 

Incomplete  double  entry,  44-45,  152-53 
Insolvency 

deficiency  account,  378-83 

statement  of  affairs.  372-78 

statement  of  realization  and  liquida- 
tion, 383-95 

Insurance,  46-48,  132-33,  251 
Intangible  fixed  assets,  179,  191-96 
Intercompany  sales,  407-9 
Inventories 

asset.  46-48,  132-34 

liability,  49-50,  133-34 

perpetual,   172,  243-46 

physical,   34-36,   167-78 

positive  and  negative,  46-50 
Investment 

as  an  asset,  188-91 

shown  in  proprietor's  account,  213-14 

symbolized,   3-19 

Journals 

cash,  65-75 

columnar,    55-61 

definition  of.  39-40.  53-55,  101 

kinds  of,  41,  53-105 

notes  and  bills,  75-77 

posting,   40-41.   78.   101-4 

purchase,  62-64,  89 

record  of  discounts,  71-75 

sales,  62-64 

special,  41 

development  of,  53-105 
relation    of,    to    control   accounts, 
77-78 

status  of,  97-101 
Junior  partners,  277-78 

Kinds  of  journals,  41,  53-105 

Land.     See  Real  estate. 
Leaseholds,  186-87 
Ledger 

balance  sheet  made  from,  106-54 

"Boston,"  88-89 

columnar,  88-89 

definition  of,  21-23.  78 

form  of  accounts,  84-87 

general,  78-79,  84 

plant,  353-56 

posting  in.  from  journal,  53-61,  101-4 

private,  79-84 

stock,  171-78 

See  also  Accounts. 
Liabilities 

accrued.   133,  198-99 

bonds.  203-11,  337-41 

classification  of.  197 

contingent,     200-203,     331,     335-36, 
352-53 

current,  197-99 

deferred,   133-34.   199-200 

dividends,  184,  199,  327 

inventories,   49-50,   133-34 

mortgages,  203-11 

statement  of.  under  single  entry,  45 

symbolized,  3-19 

wages.  198-99 

See  also  Accounts;  Insolvency. 


Limitations 

of  balance  sheet  115-16,  147-52 

of  trial  balance,  25,  107-9 
Liquid  assets,  157-58.     See  also  Assets. 
Liquidation,    statement    of    realization 

and.  383-95 

Liquidation  of  partnership,  284-94 
Loss 

arrived  at  by  inventory,  33-35 

kinds  of,  215-16 

symbolized,  8-19 

See  also  Profit  and  loss  account. 

Machinery,  148-52.  187-88,  354-56 
Manufacturing  statement,  233-37 
Materials  in  process.  170-71.  See  also 

Working  assets. 
Memoranda  of  entries  in  ledger.     See 

journals. 
Merchandise 

account,  development  of,  33-36 

as  an  asset,  167,  178 

how  entered,  27-28 

symbolized,  3-19 
Mining  companies,  323-24 
Minority  interests,  405-7 
Mixed  accounts,  35-36,  116-18 
Models,  as  illustrating  the  function  of 

accounts,  1-2 
Money 

checks,  161 

nature  of,  156-57 

paper.  161 

See  also  Cash. 
Mortgages,  203-11 

Necessity  of  accounts,  1 
Nominal  accounts,   33.     See  also  Pro- 
prietor's account. 
Notes  and  bills  journal.  75-77 
Notes    payable,    198 
Notes  receivable,  165-66,  200-203 

Obligations,    secured,    unsecured,    and 

partly  secured,  373 
Organization  expense,  196 
Overhead,  246 

Partnership 

accounting,  difficulties  of,  275 

articles  of,  275-77 

capital  in,  275-94 

changed  to  corporation,  317-21 

definition  of,  217-19 

formation  of,  278-81 

interest  on  capital.  281-84 

junior  partners.  277-78 

liquidation  of,   284-94 

profit  and  loss  in,  275-81,  284-94 
Period,  accounting,  36-38,  131-34 
Perpetual  inventory.   172,  243-46 
Plant  ledger,  353-56 
Posting 

definition  of,  40-41 

technique  of,  101-4 
Preferred  obligations,  373 
Preferred  stock,  297 
Preliminary  survey  of  accounting,  1-19 
Premium 

on  bonds,  189-90 

on  stocks,  302-3 


414 


Index 


Prime  cost,  246 
Private  cash,   83 
Private  Journal.  82-83 
Private  ledger,  79-84 
Profit 

arrived  at  through  inventory,  33-35 

definition  of,  160 

factory,  246-47 

gross  and  net.  222-23 

in  intercompany  sales,   408 

of  corporations,   322-25 

of  partnerships,  275-94 

symbolized,   4-19 

undivided,  221 

Bee  also  Profit  and  loss  account. 
Profit  and  loss  account 

allocation,  214 

definition  of,  50 

functional  idea   in,   238-39 

in  corporations,  322-23 

use  of.   110-12,  125,  147,  212-17 
Profit  and  loss  statement,   37-38,   213- 

15,   228-33.   237-40,  243-74 
Proprietor's  account 

analysis    of,    29-33,    153-54,    212-15, 
222-29 

classes  of  proprietorship,  217-21 

consolidating,  50,  110-12,  125,  153-54 

corporation.  219-21,  300-328 

definition  of,  29,  212 

effect    of    typical    transactions    on, 
126-34 

entries  in,  215-16 

expenses,  224-27,  259-74 

holding  companies,  396-409 

in  insolvency,  376 

manufacturing  statement,  233-37 

partnership,   217-19,  275-94 

railroad  income  statement,  253-58 

reserves,  221,  301-2,  329-44 

sole  proprietorship,   217 

subsidiary,  30-33,  216-17 

surplus    account.      See    Surplus    ac- 
count. 

symbolized,  5-6 

trading  statement.  222-23,  240-42 

See  also  Closing  entries;  Profit  and 

loss  account. 
Purchases 

entered,   23,   35-36,    171 

purchase  journal,  62-64,  89 

symbolized,  3-19 

voucher  register,  89-101 

Railroad 

depreciation,  370-71 

expense  apportionment,   271 

income  statement,  253-58 

secret  reserve,  343 
Real  accounts,   33,  212 
Real  estate 

account,  26-27 

as  an  asset,  178-87 
Realization  and  liquidation,   statement 

of/383-95 
Receipts.     See  Cash. 


Receiver.     See  Insolvency. 
Register,  voucher,  89-101 
Replacements,  353,  369-70 
Requisitions,  recapitulation  of,  174 
Reserves 

definition   of,    221,   301-2 

effect  of,   on   balance-sheet  interpre- 
tation, 332-37 

in  insolvency,  377 

reserve  funds,  335-37 

secret,  342-43 

sinking  funds,  337-41 

surplus,  330-32 

valuation  accounts,  329-30 
Resources,   statement   of,  under  single 
entry,  45,  153 

Sales 

entered,  35-36 

sales  journal,  62-64 

symbolized,  3-19 
Scales,    as   a   symbol,    2-18 
Scrip  dividends,  326-28 
Secret   reserves,   342-44 
Single  entry.  44-45,  152-53 
Sinking  funds,  337-41 
Sprague,  Charles  E..  The  Accountancy 

of  Investment,  210 
Statement 

deficiency  account,   378-83 

manufacturing,  233-37 

of  affairs,  372-78 

of  profit   and   loss.     See  Profit  and 
loss  statement. 

of  realization  and  liquidation,  383-95 

of  receipts  and  disbursements,  253 

of  resources  and  liabilities,  45,  153 

trading,  222-23.  240-42 
Stock  ledger,  171-78 
Stocks,   184,   188-8a,  295-97.     See  also 

Capital  stock. 
Subsidiary  accounts 

payable,  42-44,  62-63 

proprietor's,   30-33,  216-17,  263-66 

receivable,  42-44,  62 
Surplus    account,    221,    242-43,    301-3, 

330-32 

Survey,  preliminary,  1-19 
Symbols,  use  of,  1-19 


Taxes,  251 

Trading  statement.  222-23,  240-42 
Treasury  bonds,  210-11 
Treasury  stock,  303-5,  310-13 
Trial  balance 

and   the   balance  sheet,   106-13,   121- 
47 

definition  of,   24-25 

of  general  and  private  ledgers,  80 

of  private  ledger,  83     • 
Trust.     See  Holding  companies. 

Unissued  bonds,  211 
Unissued  stock,  303-5,  316-17 
Utility,  158-60 


- 


Index  415 


Valuation  of  assets  Wages,  198-99.     See  also  Expenses, 

basis  of.  160  Wasting  assets,  183-84,  323-24 

current  assets,  160-67,  178  Working  asspfs    1^8    1R778 

fixed  assets,  147-52,  178-96,  323-24  Work  ™  hflancP  sheet    1 16  W    14^  47 

valuation  account,  163-64,  329-30  Working  balance  sheet,  116  d9,  1 

working  assets,  167-78 

See  also  Depreciation ;  Insolvency.  Young  men  admitted  to  firm  as  junior 
Voucher  register,  89-101  partners,  277-78 


YC  39248 


